Office Depot, Inc. F3Q08 (Qtr End 9/27/2008) Earnings Call Transcript

Oct.29.08 | About: Office Depot (ODP)

Office Depot, Inc. (NASDAQ:ODP)

F3Q08 Earnings Call

October 29, 2008 9:00 am ET

Executives

Brian Turcotte – Vice President, Investor Relations

Steve Odland – Chairman, Chief Executive Officer

Mike Newman – Chief Financial Officer

Carl Rubin – President, North American Retail

Steve Schmidt – President, North American Business Solutions

Charles E. Brown – President of International

Analysts

Matthew Fassler – Goldman Sachs

Christopher Horvers – J.P. Morgan

Michael Baker – Deutsche Bank Securities

Kate McShane – Citigroup

Oliver Wintermantel – Morgan Stanley

Colin McGranahan – Sanford C. Bernstein & Co., LLC

Daniel Binder – Jefferies & Co.

Operator

Good morning and welcome to the third quarter 2008 earnings conference call. (Operator Instructions) I would now like to introduce Mr. Brian Turcotte, Vice President of Investor Relations, who will make a few opening comments. Mr. Turcotte, you may begin.

Brian Turcotte

Thank you Shirley. Before we begin, I would like to remind you that our discussion this morning may include forward-looking statements which are subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements reflect the company’s current expectations concerning future events and are subject to a number of factors and uncertainties that could cause actual results to differ materially. A detailed discussion of these factors and uncertainties is contained in the company’s filings with the SEC.

The press release and accompanying webcast slides for today’s call are available on our website at www.officedepot.com. Click on Investor Relations under Company Information. I would now like to introduce Office Depot’s Chairman and Chief Executive Officer, Steve Odland. Steve.

Steve Odland

Good morning and thank you for joining us for Office Depot’s third quarter 2008 conference call. With me today are Mike Newman, Chief Financial Officer; Chuck Rubin, President of North American Retail; Steve Schmidt, President, North American Business Solutions; and Charlie Brown, the President of International.

Before I review our third quarter results, I’d like to welcome Mike Newman to our executive team. For those of you who don’t know Mike, he has 30 years of financial experience including CFO positions at Radio Shack, Intimate Brands, and Hussman International. He also spent 17 years at GE in a variety of management roles in the U.S. and in Europe. Mike brings strong financial skills and a wealth of operating experience to Office Depot and we’re very pleased that he has joined the company.

In addition I’d like to thank Charlie Brown for serving as the Acting CFO during the six month search process, in addition to his duties as President of International. Charlie did a great job managing the finance organization during the transition and we can now let him go back to focusing all his efforts on running the International business.

Looking at the third quarter, our performance was representative of the unprecedented time in which we live. The global liquidity crisis has created an environment in which small and large businesses as well as consumers have reduced their spending for products and services. In the case of Office Depot our sales were below expectations, particularly late in the quarter, as our customers were significantly impacted by the global liquidity crisis and cutbacks.

As we go through the call today the division presidents, Mike, and I will share our strategies on how we plan to successfully manage the company through this challenging period. Third quarter 2008 total company sales were $3.7 billion, a decrease of 7% compared to third quarter results last year. Our net loss on a GAAP basis was $7 million compared to earnings of $117 million in the third quarter of 2007. The GAAP loss per share was on a diluted basis was $0.02 for the quarter versus the diluted earnings per share of $0.43 a year ago.

Adjusted for charges the diluted loss per share for the third quarter of 2008 was $0.01 versus earnings of $0.43 a year ago. Now I should note that the retroactive UK tax law change that we referred to last quarter had an $8 million or $0.03 per share negative impact on our third quarter 2008 results. In addition, within North American retail the store impairment and closer costs had a $21 million pretax impact or $0.05 per share negative impact on the quarter.

Total operating expenses as a percentage of sales for the third quarter of 2008 were 27.7% compared to 25.2% for the same quarter of the prior year. Third quarter 2008 operating expenses included lower bonus accrual reversals versus year ago, resulting in comparably higher compensation costs in the third quarter of 2008. The increase in operating expenses also reflects approximately a $21 million charge for North American retail store impairment and closure costs I mentioned earlier, as well as higher corporate charges for professional and legal fees and de-leveraging of costs against the lower sales levels.

EBIT adjusted for charges was $15 million in the third quarter of 2008 or 0.4% of sales compared to $128 million or 3.3% in the same period last year. Although we are extremely disappointed in our third quarter results during these challenging times, I assure that the management team and associates at Office Depot have and will continue to do everything we can to manage the top line, cut costs, reduce our capital spending and improve our cash flow. This focus on cash flow is paying off.

In the third quarter our cash flow from operating activities was $261 million and we generated

$190 million in free cash flow, despite our earnings. Now I’ll turn over the call to Chuck Rubin to talk about North American retail.

Carl Rubin

Thanks Steve. Good morning. Third quarter sales in the North American Retail division were down 11% to $1.6 billion. Comparable store sales in the 1,203 stores in the U.S. and Canada that have been open for more than one year decreased 14% versus the third quarter last year. It’s worth noting that our sales costs in the first six weeks of the quarter actually improved versus the second quarter average of minus ten, but then fell significantly in the back half of the quarter, especially in the last couple of weeks due to the worsening economic crisis which limited liquidity for our small business customers.

North American Retail experienced sales declines in our three major product categories of furniture, supplies and technology in the quarter. Sales of laptops and business machines in particular were down as our small business customers reduced their spend on big ticket and discretionary items and focused their purchases on our core supplies. Our best performing product lines were ink and toner, paper, and design print and ship services.

We continue to be negatively impacted by weakening business conditions in North America. Although it appears that the rate of sales decline in California has been consistent over the past few quarters, Florida our largest and most profitable market and the other markets in which we operate experienced a steeper decline in demand. The sales comp decline was driven by both a reduction in the number of store transactions and increased softness in average order values versus the same period one year ago.

Although most of the decline can be attributed to macroeconomic factors, a conscious effort to reduce our marketing efforts for low margin technology items in the third quarter also negatively impacted the top line, but improved our product margins. Additionally, Hurricanes Gustav and Ike had a 40 basis point negative impact on sales comps.

In the third quarter we opened six new stores, closed three, and relocated two, bringing our total store count to 1,275. We also remodeled two stores in the third quarter. We continue to be very pleased with the progress made with our service levels in store. Mystery shop scores were 95% in the third quarter, up 2% versus last year and our in stock levels were also quite good.

Operating profit for the North American Retail division was $12 million in the third quarter of 2008. This includes a charge of approximately $21 million for store impairment and closure costs. While we typically have some level of store impairment charges, this is about $17 million above the amount we recognized in the third quarter of last year.

In the fourth quarter we will evaluate our store base for potential closures. We cannot predict today the extent or magnitude of those potential closures and related charges, but they may include acid impairments, severance costs and provisions for future lease commitments.

Including the store impairment charge, operating profit as a percentage of sales decreased 370 basis points to 0.8% versus 4.5% in the third quarter of 2007. The key components of operating margin change versus a year ago include the following. On the positive side, our product margins were higher than last year by approximately 170 basis points, due primarily to improved product mix and less inventory clearancing, offset partially by increased costs associated with mail in rebates.

On the negative side, lower sales levels caused fixed costs and operating expense de-leveraging which reduced margins by approximately 300 basis points compared to last year. About 60% of that de-leveraging relates to property costs and the remainder from base operations such as payroll. Second, based on the result of the store impairment testing, we recognized an impairment charge of approximately $20 million in third quarter 2008 compared to approximately $3 million in the third quarter of 2007.

Additionally, we incurred $1 million related to store closure costs, higher than the third quarter of 2007. The charges for impairment and closure costs resulted in a decrease in operating margin of approximately 110 basis points. Third, shrink and higher supply chain costs driven by fuel costs and de-leveraging reduced margins by about 60 basis points. Fourth, we experienced a negative impact of approximately 30 basis points due to the hurricanes in Houston and the Gulf Coast region. And fifth, lower bonus accrual reversals versus a year ago and other items combined decreased operating margin by approximately 40 basis points.

Last quarter I outlined the actions we’re taking to improve our operating margins going forward and I’ll summarize them for you as well as any progress made. First we accelerated our product assortment review to reduce our overall SKU count. We continued to complete additional line reviews resulting in significant cost savings on our future purchases which will certainly improve our future margins.

Second, we are micro assorting our key technology departments to better match our offerings to the individual store sales volume and customer profile. This action reduced end of quarter clearancing in the third quarter.

Third, we’ve implemented stringent inventory controls to support our more conservative sales forecast. Our end of quarter per store inventory in the third quarter was $770,000, down 15% from the same period one year ago. These controls should reduce end of line clearancing and improve margins and cash flow.

Fourth, we have significantly reduced our new store opening plans with only three planned for the balance of the year. These three stores have committed leases which would cost us more to break than to actually open the stores.

Fifth, we are slowing our remodeling efforts. For the balance of this year we anticipate remodeling seven more stores and they will be landlord funded. And sixth, we continue to manage our in store costs while protecting our commitment to high service levels.

I’d also like to update you on a few of the Taking Care of Business key actions to improve our sales going forward. First we continued to address our customers increasing need for low prices and high value. For example, in the third quarter we continued to expand our smaller pack size offering and leveraged high traffic areas for entry price point products. Second, we continued to target our Worklife Reward Loyalty members, building our file in the third quarter by double digits versus a year ago.

Third, to fulfill the unmet needs of micro business customers, we rolled out our Tech Depot service offering to all stores during the third quarter and we’re pleased with the performance to date.

In summary, although not happy with our results, we do believe the actions we’re taking in the current economic environment will provide significant leverage when sales do improve. Now I’d like to turn the call over to Steve Schmidt to review North American Business Solutions.

Steven M. Schmidt

Thanks Chuck. Total sales in the North American Business Solutions division were $1.1 billion, down 10% versus the third quarter of last year. This decline was driven by further deterioration in our small to medium size customer base, a significant reversal in the sales growth print among our large national account customers and public sector, and declining growth in our technology and furniture businesses as customers refocused their spending on core office supplies.

Business Solutions sales in Florida and California continue to be challenged due to state mandates to reduce expenditures and budgetary issues, as well as reduced liquidity among companies as a result of the banking crisis. We have also seen business declines outside of Florida and California, as the economic woes have spread across the nation.

The North American Business Solutions division had an operating profit of $39 million for the third quarter of 2008 compared to $69 million for the same period prior year. The operating margin was 3.7% in the third quarter of 2008, down from 5.9% in the same period in 2007. On a sequential basis, operating margins were down 90 basis points due to the unfavorable product and customer mix, higher advertising expending, and de-leveraging of fixed costs driven by the revenue decline.

The components of the operating margin decline versus one year ago included the following key factors. First, approximately 90 basis points of this decline relates to product margin, including increased promotional activity and customer rebates. Second, an increase in advertising spend, primarily in the direct business, reduced operating margin by about 90 basis points.

And third, operating margin declined 40 basis points due to lower bonus accrual reversals versus a year ago and the de-leveraging of costs against lower sales levels, partially offset by an increase in vendor program support.

I’d now like to update you on the action plans that are focused on taking care of business in the North American Business Solutions area. First, we implemented at our contact strategy in the third quarter and it had a positive impact on our sales organization. The strategy allows us to continue to aggressively pursue small to medium size business customer using the tools and processes of this initiative.

Unfortunately, many of these small to medium sized businesses have increasingly pulled back on office supply purchases in the midst of worsening economic conditions. In addition, our contract customers are spending less on discretionary items as they have come under increasing pressure to reduce their budgets. As a result, we do not believe the improvements that we have made are truly reflected in our third quarter results.

Second, we continue to make progress with our Telephone Account Management or TAM organization. We have improved the management of the third party firms who handle this business and have made progress on the key performance indicators that we have put in place. We have also added third party sales representatives to increase our focus on customer prospecting.

Third, our direct business also continues to make progress and so we are implementing catalog analytics and increased catalog distribution. We continue to test our number of marketing and strategies and will incorporate the lessons learned from each of these tests.

And fourth, we continue to execute our website optimization plan, where we look to improve the usability of the site as well as make customer focused enhancements. While our customer conversion rates rank among the best in the industry, we will continue to make improvements to the website in order to make the site more user friendly for the end user.

Our Internet sales on a global basis continue to grow in 2008, with sales from the previous 12 months totaling $4.9 billion compared to $4.8 billion for the same period a year ago. In the third quarter 81% of total BSD sales were online, up from 79% in the same period a year ago.

We continue to aggressively defend our state contract businesses while at the same time make progress with existing state bids. For example, we were recently awarded a sole source supply contract in the state of Nebraska and a portion of a multi-source contract in the state of

New York following competitive bid processes.

In summary, we will continue to focus on executing our key initiatives in managing our expenses during these challenging market conditions. Charlie will now discuss the results of our International business.

Charles E. Brown

Thanks Steve. The International division reported sales of $1 billion in the third quarter, an increase of 3% compared to the same period a year ago. In local currency, sales decreased 2% with nearly all European countries reporting year-over-year declines. Sales in the direct channel were down 7% in local currencies as a result of a growing number of value seeking customers and increased competitiveness within the channel.

The contract channel continued to outperform direct, increasing sales by 3% in local currencies. However, sales weakened during the quarter as many of our large accounts came under pressure to reduce spending wherever possible.

As I’ve mentioned on previous calls, the economic downturn in Europe originated in the UK last fall and has steadily worsened. Earlier this year, the downturn spread to the continent with France, Ireland and Denmark having officially declared recession. Economists are also predicting that the UK, Germany and Spain are at substantial risk of falling into recession. As a result of the weakening economies and growing liquidity concerns, businesses both small and large are finding it more difficult to finance and grow their businesses.

This has a direct impact on their purchases of office supplies and services. Division operating profit was $36 million in the third quarter compared to $47 million in the third quarter a year ago. Operating margin was 3.5% down from the 4.7% last year. The components of the operating margin declined versus a year ago include lower bonus accrual reversals versus a year ago accounted for about 70 basis points of the decline.

Second, lower sales volume de-leveraged our fixed expenses which accounted also for 70 basis points of the margin decline. And third, unfavorable foreign exchange acquisitions and other small items negatively impacted margin by 40 basis points. Partially offsetting the overall decline was an improvement in the UK’s operating performance which contributed 60 basis points of positive improvement.

While business conditions continue to be very challenging, we are moving forward with our previously announced action plans. I’d now like to update you on our progress. First in the UK we have substantially improved our performance, with our supply chain and customer service metrics dramatically better than at this time last year. These improvements are reflected in the improved financial performance of this important market.

Second, our Tech Depot business has been rolled out to the UK and the Netherlands, with France and Germany scheduled for roll out over the next few months. The performance of this asset like model are meeting our expectations.

Third, we expect to test text services next year in France. This is the same offering that has been fully deployed in our North American Retail business. Fourth, we continue to transition the back office transaction accounting functions to our assured service facility in Eastern Europe. To date, the UK, France, and Germany have been completed and we’re now in the process of transitioning Spain and Italy. We remain on track to have the balance of Europe completed by year end.

And fifth, we continue to leverage our global sourcing office and have seen increases in product brand sourcing penetration rates and volume as a result. While we are still in the early stages of this initiative, we view direct sourcing as an enormous margin enhancing opportunity for our businesses across the globe.

I’ll now provide an update on the unsolicited non-binding proposal for our partner in our Mexican joint venture. We have not moved forward with selling our investment in the Mexican joint venture but continue to engage in discussions with our partner regarding strategic alternatives for the business that will add to cash flow and increase shareholder value. Decisions regarding alternatives for this business would need to consider among other things the share repurchase restrictions in our asset based loan facility, which currently prohibits share repurchases.

In addition, the proceeds received from a potential sale would be reduced by about 40% due to taxes. As I discussed last quarter the Mexican business is very profitable and we expect it to contribute between $35 and $40 million in net income this year to Office Depot. If we had taken our partner’s original offer, we would have given up our rights to a stake in the development of the South American market and the transaction would have been diluted to earnings, even if the proceeds had been used to buy back shares.

In summary, as we look forward we will continue to focus on executing our key initiatives in the International Business, reducing our capital expenditures and managing our cash flows in these difficult times. In addition, we’re pleased with the results of the small emerging acquisitions we’ve employed [inaudible] aside until we see market conditions. I’ll now turn it over to Mike who will review the company’s financial results for the quarter.

Mike Newman

Thanks Charlie. Before I review the financial results for the quarter, I’d like to say that I’m extremely excited to be part of the executive team. Although I joined Office Depot during a challenging time for both the company and the global economy, I believe that we have many opportunities to improve our financial performance, size our cost structure, reduce capital expenditures, and be positioned to capture profitable growth when the economy recovers.

My focus as CFO in the coming months will be to first assure the company has the liquidity it needs to operate in this difficult environment, second to increase the company’s free cash flow by improving working capital and reducing CapEx to a level that is appropriate for the current environment, and third review all of our business processes to see what activities we can do without.

Also in the fourth quarter, we will be conducting a strategic review of our asset base in addition to our normal annual assessment of goodwill. Examples of what will be included in this strategic review include potential sale and lease back arrangements; potentially exiting businesses with negative cash flows; and possibly closing a number of North American retail stores. We will determine in the coming months how best to change our business to succeed in the current and future anticipated economic environment.

We will likely begin taking charges in this quarter. We will also continue to make adjustments in our global workforce, including both corporate and field as our business needs dictate.

During the third quarter we recognized approximately $5 million in charges as part of the plan we announced back in 2005 bringing the total charges from inception in the third quarter of 2005 to $417 million. This quarter’s charges primarily were for severance related international projects. We anticipate charges of $8 million for the balance of 2008 and $46 million in 2009 for a program total of $471 million. However, future charges may change as plans are implemented.

In the third quarter we had $190 million in free cash flow. For our definition of free cash flow and reconciliation to a GAAP financial measure, please go to our website under Investor Relations. The principal third quarter free cash flow driver was $187 million in lower inventory versus the end of the second quarter as a result of the initiatives mentioned by Chuck Rubin.

Third quarter capital expenditures of $71 million were close to the $62 million of depreciation and amortization we recorded and we also realized nearly $50 million in proceeds from the sale and lease back of eight North American Retail stores during the quarter. Overall and in light of our business performance, we are very pleased with our cash flow performance in the third quarter.

For the nine months ended September, net cash provided by operating activities was

$398 million and free cash flow was $120 million. Next I’d like to take a moment to respond to questions we have received in regards to two issues; our new asset based credit facility and also our capital expenditure plan.

As most of you are aware we successfully closed on a new five year, $1.25 billion asset based credit facility at the end of the third quarter. The agreement is similar to other asset based facilities yet different in several ways from our previous revolver. Most importantly, this agreement does not contain a maintenance financial covenant. If you remember, our prior revolver contained both a fixed charge coverage and total leverage ratio that needed to be maintained at all points in time.

Under the new agreement, the only time we would be required to comply with the fixed cost coverage ratio would be if liquidity on the facility fell below $187.5 million or if we wanted to make certain investments or restricted payments such as dividends or share repurchases. For example, we are prohibited from repurchasing shares when our fixed cost coverage ratio falls below one, and at the end of the third quarter our fixed cost coverage ratio was approximately 0. [inaudible]

At the end of September we had drawn $365 million on the asset based facility and had

$135 million in outstanding letters of credit against the facility, leaving us with $750 million of availability. Given this availability and the $395 million in cash we had on hand at the end of September, we ended the quarter with $1.15 billion in available liquidity.

In addition, since the new asset based facility does not contain any type of a leverage test, we could go out and raise additional liquidity if necessary. Specifically we have the ability to raise another $750 million in secured debt and $650 million in unsecured or subordinated debt. And in addition to that, we will also review other internal sources of liquidity such as our own store and distribution center properties for potential sale lease back arrangements in the fourth quarter.

In regards to capital spending, we have increased our focus on CapEx and are currently reviewing our fourth quarter 2008 and full year 2009 spend. Our CapEx has been tracking nearly 20% below last year for the first nine months of 2008 and is on track to come in around

$350 million for the full year of 2008. In order to increase our cash flow in 2009 and to provide additional liquidity, we are planning on reducing our CapEx to about $225 million which is

$50 million below our expected 2009 depreciation and amortization of $275 million.

To achieve these we will decelerate the implementation of our IT and supply chain initiatives as well as limit new retail store growth.

In regard to our balance sheet, we ended the third quarter with $395 million in cash and cash equivalents. Our investment in inventory totaled $1.5 billion globally, down 9% from the same period last year and this decrease was driven primarily by lower inventory in North American Retail with inventory per store at quarter end at $770,000 per store, down 15% from the same period a year ago. This inventory reduction was the result of improved inventory management as well as mitigation of inventory risk through clearance activities.

Our net debt at the end of the third quarter was $546 million including $519 million in long term debt. With the new asset based credit facility in place and our $400 million in long term bonds not maturing until 2013, I feel comfortable that we have a capital structure in place to take us through this business cycle. And with that I’ll turn the call back over to Steve Odland.

Steve Odland

Thanks Mike. Clearly we’re disappointed in our third quarter earnings and the steep decline in our share price. Given that the world that we are operating in today - given that world our liquidity of course then is paramount and as Mike mentioned we are focusing on our cash flow and have the asset based loan facility in place if needed. As a result, even though we don’t know the depth and duration of this global crisis, we believe that our liquidity positions us well for the long term.

As Mike mentioned, we will be conducting a strategic review of our asset base in the fourth quarter, including potential sale lease back arrangements, potentially exiting businesses with negative cash flows, and potentially closing a number of North American stores. I’d like to reiterate that we are committed to managing the company through these challenging times and will continue to do everything we can to manage the top line, cut costs, reduce our capital expenditures and improve our cash flow.

With that, I’d like to open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Matthew Fassler – Goldman Sachs.

Matthew Fassler – Goldman Sachs

First of all, as you think about what you’re going to do with Mexico, why are share repurchases part of the dialog right now? Why is that limitation seem to be perhaps an influence on what you’re looking to do? To the extent that the markets concern about liquidity you might think they’re overdoing it and hence that share repurchases is appropriate here, but just talk about the way you might deploy any capital that you raise from that and why that seems to be a consideration in that thought process?

Steve Odland

No I think that all we were pointing out is that there was a lot of talk about “gee, we should monetize that asset in order to buy back our shares” and all we were pointing out is that there are limitations underneath the current asset backed facility on share repurchase. So we were pointing out that the fixed charge coverage ratio needs to be above one in order for that to be the case. Nevertheless, we do believe that that is an important asset and we have engaged in our discussion with our partners and continue those discussions.

Quite frankly, the offer changed from the initial offer. We’ve worked through that with them and continue to keep the negotiations alive. But we also are pointing out that that business is a good business. You’d lose 40% of the proceeds to taxes. So whatever the gross proceeds would be, however amended, you’d have to take 40% off of that so it’s not an efficient return of capital. And then whatever the use would be. The issue of liquidity Matt is that if we felt we needed liquidity there are a lot of places we could turn.

And what we’ve pointed out is we’ve got $1.150 billion in liquidity at the end of the quarter. We had nearly $400 million of cash on our balance sheet. We’ve got sale lease back arrangements we can do. But after all of that, of course, the Mexican business and any other business that we have is able to be monetized for cash if we wanted to do that. Hopefully that clarifies our -

Matthew Fassler – Goldman Sachs

It does. You said the offer has changed. Is it different from the dollar value that you discussed on the second quarter call?

Charles E. Brown

No, the transaction has changed. Originally it was $430 million and what they talked about doing was splitting it into $430, $30 being a fully paid up value for South America. We’d lose all that future potential. Plus their own financial situation has changed. At the time they made the offer they had $1.3 billion in cash on their balance sheet. Last we saw it was down to just around

$400, so obviously they would need to secure financing which to complete the transaction.

Matthew Fassler – Goldman Sachs

As you think about some of the larger strategic steps you want to take and you talked about strategic review at year end, how extensive of a restructuring could you imagine? And does your balance sheet or your concern about perceptions of your balance sheet limit the kinds of store closings or other asset write downs or removals that you might contemplate?

Steve Odland

Well, we’re just in the process of beginning that review and I think that nothing we’ve conceived of so far is limited by our balance sheet or our liquidity situation. We’ve got to look at everything and our business is smaller today. We’re caught up in a global crisis. We’ve got to look at cash flow, negative businesses, we’ve got to look at stores and we will do that. We just simply are starting that now and we will continue this. We expect to take these actions either during or towards the end of the fourth quarter and we’ll announce any potential charges, cash or non-cash, probably with our fourth quarter earnings.

Matthew Fassler – Goldman Sachs

Of the $21 million impairment charge, it seems like most of that impairment and closing charge I should say, it seems like most of that was non-cash. Where does the add back show up on the cash flow statement if you could just help us there?

Steve Odland

It wasn’t on cash. It was a [FAS 144] you know our annual third quarter FAS 144 assessment of our stores and so was a non-cash, it was a non-cash charge and it was in the North American Retail operating income.

Matthew Fassler – Goldman Sachs

Just to the extent that it was adapted net income on cash flow, would you know which item Charlie or Mike that was –

Charles E. Brown

Matt it would be treated the same way as depreciation and amortization. Cash flow from operations.

Steve Odland

That is an interesting point, Chuck. You might want to – those numbers for FAS 144 impairment charges are in the division numbers.

Carl Rubin

We reported 0.8% operating profit for retail. The impairment charges are included in that. So if you take that non-cash out and some other issues that were unique, like the hurricane impact, the operating margin for retail in the third quarter was in the mid to upper 2% range.

Mike Newman

If you look at the 39 weeks statement of cash flow, it’s in that changes in working capital and other line.

Operator

Your next question comes from Christopher Horvers – J.P. Morgan.

Christopher Horvers – J.P. Morgan

Can you maybe frame out from the liquidity perspective some of the things that you’re talking about here? Can you frame out on the sale lease backs side how many stores you own where you have the opportunity? Also on the DC side and perhaps geographically where that is? Just so we can get an estimate of what the potential cash flow opportunity is. And also from the store perspective it seems like you’ve changed your tone over the past – just over the past two months on that.

Prior to this you had talked about saying “well, we don’t want to exit just some stores because it’s important that we have stores and the BSD division in those regions,” so are you planning more of a regional exit?

Carl Rubin

I think we’ve said all along that we believe in our store model long term. What we’ve talked about on this call is that we’re going through the process of evaluating all of our stores, given the current economic situation. We haven’t made any decision. We’re not finished with the analysis that we’re doing.

But I don’t think that our strategy has changed radically other than just a recognition that we’re dealing in a unique time and we have to, as we do every year, visit our store profit abilities and cash flow. So we’ll keep you up to date as this thing evolves, but your comment about the synergies between BSD and retail are still there. Steve Schmidt and I see that in both of our businesses and the closer we work together the more – the better the results are.

Steve Odland

Mike, do you want – you may just want to talk about the sale lease back opportunities.

Mike Newman

Yes, there’s another on the sale lease back in addition to the eight that we did in the third quarter. There’s another 40 to 50 that we’re looking at and we’re going to see – we want to make sure they’re smart economic deals. We also have some warehouses and facilities internationally that we’re looking at as well. At this point I’d prefer not to size it, but it could be at least as large as the opportunity we reported in the third quarter.

Christopher Horvers – J.P. Morgan

On the store closure side, does then the BSD synergy in order of magnitude try to help frame it, does the BSD synergy then suggest “well, we could close 20 to 30 stores” now “100 to 200 stores” and then also on the store exit side, how much is it typically to exit a lease for the stores now?

Steve Odland

We’re not at the point, Chris, where we’re able to say how many stores could potentially be affected here. I know people would like to have that number, but we simply are going through the analysis today and we’re taking every aspect of that into consideration, including the BSD synergy and the location of the stores, the long term future of the stores. We don’t want to just make short term decisions based on this quarter’s operating environment and damage our long term business but we do want to be responsive the business situation.

We don’t know how long this crisis will last. We don’t know how long the business downturn will last. I just would remind everybody all of our sales are office supplies. These are G&A expenses for our customers and therefore they’re discretionary expenses for all of our customers. And our business model relies on the health of the economy and spending by our small, medium and large business customers.

And especially on the small side, we started to see the impact a year ago and that has been hit dramatically particularly in the last two weeks of the third quarter as we saw the global liquidity crisis hit. So we’re in unprecedented times where people just simply have cut back severely on their spending. I think every company that’s on this call has cut back on their G&A expenditures. So that’s the time we live in. So we don’t know how long that’s going to last. What we’re saying is we’ve got to adjust to that and be responsive to that and that’s what we’re looking to do here.

In terms of the cost, the potential cost per store, Mike, you may want to mention that.

Mike Newman

I think at this point I’d wait until we did further analysis before I do that.

Steve Odland

It is variable by store. It depends on the lease length and the expenses and how much we have into the store, Chris.

Christopher Horvers – J.P. Morgan

How do you, as you think about inventory and accounts payable into year end, do you think you can maintain that 93-ish percent AP to inventory ratio and down 10, down 12 inventory growth?

Mike Newman

Yes, we do. I mean obviously with inventory where it is, the idea that there’s additional opportunity off that is a little tight, but we think we actually have some opportunity in payables and yes we think we can maintain that relationship.

Steve Odland

Understand the inventory decline. We’ve been able to take a lot of inventory out in this period of time while at the same time improving our store in stock conditions. And that is paramount to us. Our customer facing in stock conditions and inventory are very important, both to the BSD division as well as in retail. The place where we’ve been able to affect inventory is through supply chain changes.

We’ve implemented some creative opportunities in alternate sourcing between our facilities so that we don’t have to carry the safety stock in every single one of our DC’s. We’re alternating in moving product between stores more to try to balance out inventories. Chuck has done a great job with the merchants micro sorting, especially big ticket items in stores so that we don’t just peanut butter all of our inventory across every store regardless of customer demand in those stores.

So these are some very creative and aggressive techniques that we’ve used that have actually improved our customer facing conditions. So we continue to believe that we can do more of that in the fourth quarter and take inventory out and improve our cash flows while not negatively impacting our customers’ situation.

Operator

Your next question comes from Michael Baker – Deutsche Bank Securities.

Michael Baker – Deutsche Bank Securities

You spoke about some money losing businesses. I’m wondering if you can give us an example of what you might be talking about? And I guess does that include when you talk about a business is that a geographic segment perhaps count as a sort of money losing or stand alone business? I’m just trying to understand what you mean by that comment.

Charles E. Brown

Probably the best example would be the business that we have in Japan. We’ve been in Japan for about 12 years, first as a joint venture and more recently as a stand alone operation. And that business it doesn’t make money. The Japanese market is a very tough market to begin with for American companies and as a matter of fact, the economy and the office products industry itself in Japan is actually shrinking.

So we’re in the process as part of the strategic review, we don’t want to specifically exit the market but we want to find alternatives in that market that would move us closer to profitability.

Michael Baker – Deutsche Bank Securities

Sorry. I was going to ask if you’d disclose the size but I didn’t mean to cut you off.

Charles E. Brown

No, no. We’d rather not disclose the size of it but at any rate it’s important for us to look at. It’s meaningful.

Steve Odland

But Mike that’s just an example and so any geography where we’re – where we are not making money, any store where we’re not making money and customer, BSD customer where we’re not making money, we’re just simply slicing and dicing the business, and saying “hey look we’ve got to reflect the realities of today’s business”. We’ve got to go through and make sure we understand that we’ve got to have positive cash flow in every element of our business.

And then we’ll take whatever actions we think are required here in the fourth quarter in order to maintain our long term business prospects while adjusting the business to the short term realities.

Michael Baker – Deutsche Bank Securities

On your charges you took a – you have a charge or a capitalcy, I think you referred to it of

$5 million that gets you to the loss of $0.01. But that minus $0.01 includes, you keep in the

$21 million impairment charges and then the $0.03 on the tax thing? Is that right?

Mike Newman

No. On a GAAP basis we recorded $0.02. The charge of $5 million that’s additional $0.01, that relates to the restructuring we started in 2005 which gets you to minus $0.01. And then you would add back $0.05 for the FAS 144 store impairment, and you’d add $0.03 back for UK.

Michael Baker – Deutsche Bank Securities

So if you want to exclude – if one were wanting to exclude all those charges, then it would be more like $0.07.

Mike Newman

Bingo.

Operator

Your next question comes from Kate McShane – Citigroup.

Kate McShane – Citigroup

A question about your real estate commitments so far for 2009. Are you committed to any real estate so far?

Carl Rubin

Yes, Kate, we’ve talked before that we’ve worked aggressively to reduce our store opening plans over the next couple of years. We’re still sitting at about 40 planned openings next year. Those are all committed leases. We have done the analysis of the financials on trying to get out of the lease versus opening it, and right now they all come back to that it’s more financially astute to open those sites. Now we continue to work on those sites. We would like to reduce that further, but today we’re sitting at about 40.

Steve Odland

These are signed leases, but we’ll also look at whether it makes sense to keep them dark, even though they’re signed and pay the rent for some period of time until the economy picks back up. So we’re going to look at every aspect of this. We’re not rushing to open stores in this environment.

Kate McShane – Citigroup

Can you comment at all what you’ve seen so far this first couple weeks of the fourth quarter? Has the deterioration you saw at the end of the quarter worsened?

Carl Rubin

Yes, our business continues to track in a similar fashion to what we saw at the end of third quarter.

Kate McShane – Citigroup

And then my final question is about international markets where you saw more intense competition. And I assume you’re talking about price competition. Can you give us a little bit more detail on that?

Charles E. Brown

The situation internationally is really very much similar to here in the U.S. Everyone is scrambling for business as the economy has slowed down. And some of the large customers have specifically instructed their employees to reduce indirect spend. And so in that environment it’s been more aggressive as to maintain our business.

Operator

Your next question comes from Oliver Wintermantel – Morgan Stanley.

Oliver Wintermantel – Morgan Stanley

You mentioned a further deterioration in your small and medium size customer base. Could you tell us if that was all macro driven? Or if you lost market share in that segment?

Steven M. Schmidt

As we look at the SMB sector, the majority of the decline is macro related. The state of Florida and the state of California continue to degregate in performance but as we said the macroeconomic pressure is obviously being seen across the country in most of our state business as well as our contract business. So the majority of it is macro driven. From a market share standpoint within BSD, we really don’t have specific market share data. But from a gut standpoint and based on what we think is happening in the marketplace, we’re trying to hold and grow share.

We think we’re holding and growing share in the education sector, government sector, our large corporate customer base, and obviously challenged in the SMB sector.

Oliver Wintermantel – Morgan Stanley

What are the specific levers that you can pull in the fourth quarter to reduce SG&A dollars or is that pretty much fixed at this point?

Steve Odland

Well, as part of our restructuring we’re looking at our SG&A as well, Oliver. We continue to scale the size of our business and the size of our employment base to that throughout North American Retail and our field operations and our selling organizations, and then globally by country where the economies are not good. So we’ll continue to do the best we can. Obviously, and especially in retail, SG&A levels reach a bit of fixed levels. You simply have to keep the lights on in the stores and a certain base of staffing in the stores in order to be customer facing.

And so at some point they act a little more fixed than they do variable. But we will continue to work very hard on our SG&A to right size that for the business that we have today.

Operator

Your next question comes from Colin McGranahan – Sanford C. Bernstein & Co., LLC.

Colin McGranahan – Sanford C. Bernstein & Co., LLC

Just back on the G&A the growth in the third quarter it looks like about 20% growth in dollars. How much of that was the reversal of bonus accruals and if you could just comment on that growth otherwise?

Mike Newman

G&A bonus accruals was probably over $15 million. We had some advertising increases and then we also had the impact from international acquisitions. Those are the big pieces.

Colin McGranahan – Sanford C. Bernstein & Co., LLC

Secondly, I know you typically don’t provide a whole lot of guidance but given the current situation, the level of uncertainty, the stock price, could you tell us what you think your cash flow outlook will be for the year and how much you think you’ll be drawing on the credit facility at year end?

Mike Newman

We currently at the end of the third quarter we were drawn on the credit facility as I mentioned in my script to the tune of about $500 million. Based on the projections we see going forward we see a draw to the tune of $500 to $600 million for the next four to five quarters, which of course indicates that we see the likelihood that with the CapEx reductions in the working capital management that we can generate free cash flow next year, even in this down environment.

I don’t really want to dimensionalize that just because of the uncertainty of the top line, but the pieces that we can control we feel comfortable with, particularly the CapEx to depreciation relationship I alluded to.

Steve Odland

And in that draw remember that we’ve got about $395 million of cash on the balance sheet right now.

Mike Newman

And that’s a great point. We probably drew $150 million plus of excess cash that we had at the end of the third quarter to get ourselves comfortable with the liquidity crisis. We did not need to draw that much.

Steve Odland

So the cash on the balance sheet alone was $1.44 a share.

Colin McGranahan – Sanford C. Bernstein & Co., LLC

Just in terms of thinking about the business, where you are today, the liquidity situation, obviously you think about assets and the stock price, how seriously will you think about something more significant? And let me throw something out at you. Your international business looks like if I allocate G&A to that business, looks like it’ll generate something around $62 million in EBIT this year. I’d assume it probably has about a third of depreciation so we can call it something like

$150 million in EBITDA for that division.

Staples bought Corporate Express at something close to 10 times EBITDA, so it seems like maybe you could sell that division for something like $1.5 billion. Your stock price is $500 million. You could sell the division, pay off your ADL and buy the whole company and have a total North American business for free. I mean, is that something you would consider? And I know you’ve talked about a total strategic review but given where the stock price is, how seriously are you going to think about something more transformational?

Steve Odland

The stock price makes no sense to us whatsoever. If you just look ex charges, EPS were largely consistent with expectations. Ex charges, North American operating margins were in the mid two to three range. Free cash flow was $195 million or $0.71 a share. The cash on the balance sheet of $1.44. Available liquidity is $1.150 billion. The stock price doesn’t make any sense. We could monetize any part of our business. We could see the North American Retail business.

We could sell the North American Business Solutions. We could sell country by country. We could package the whole thing. All of these things clearly have been discussed at least on our level and have not gone unnoticed. What we are setting out to try to do is to assure and inform everybody of our liquidity situation. You would have to believe that in order to justify the stock price that we have today, you would have to believe that we were at the end of our liquidity, which is simply untrue.

And I think we’ve dimensionalized that this morning. So you know all of these things are possibilities, even the things that you’ve outlined, but we want to make sure that we make people understand that our business is discretionary spend for everybody else. We are in a global crisis right now and the question is how long is it going to last? We simply don’t know the answer to that. We want to make the right short term decisions for the business. We also want to make the right long term decisions.

So all of these kinds of things certainly have been considered but at the end of the day it still is a great franchise with great cash flow production possibilities even in these down times. I think Mike just dimensionalized that. And the question is how extreme should our actions be in the face of a short term situation when six months, a year from now we could find ourselves with a great growth business all over again? And those are really good questions, Colin, and we’ll evaluate all of it.

Operator

Your next question comes from Daniel Binder – Jefferies & Co.

Daniel Binder – Jefferies & Co.

Back to your comments last quarter about not expecting to close a significant number of stores, obviously some time has passed, things have gotten a little bit tougher. What’s sort of the driving decision behind now doing this review and potentially closing more than just a few stores? And in that commentary, could you include how many of the stores are cash flow negative at this point?

Steve Odland

We don’t have specifics at this point, Dan, because we’re just starting the process now. I think part of it is an annual process that we go through. We do it in the fourth quarter every year. We’ve done it in the fourth quarter the last three or four years and we’ve talked about it. So part of it’s that. Part of it though is simply looking at the business more directly and trying to take more dramatic action to improve our cash flow and improve our shareholder value.

So I think that if there were normal economic times we probably would be closing no stores, because those stores would be cash flow positive and growing nicely and so forth. In this economic time and with an uncertain future, you know the economists are projecting that this kind of a situation is going to last through 2009 and is going to take until the beginning of 2010. We don’t know whether that’s reality or not. But we have to assume that 2009 is going to look a lot like the back part of 2008 here.

If that’s the case then simply it does make sense to close stores and maybe shrink in our size a little bit before we start growing again. So that’s the view that we have on this thing. And we hope that people understand that we are being very responsive to the current situation, while at the same time being very cautious not to damage our long term, strategic situation because we do believe that this company can – will take off again once the economic conditions change.

We think that we’re overexposed to Florida and California. We’ve known that for some time, which is why we tried to diversify. And I think we’ve done a good job with diversifying through our acquisitions in our emerging markets. We’re very pleased with China and India, Eastern Europe. So this is not a situation where we’re trying to move too dramatically, but we are just simply trying to adjust to the projections of the business today and what we’re hearing the economic projections will be for 2009.

Daniel Binder – Jefferies & Co.

Could you put some bookends on the potential range of stores that you’re looking at that are at least under consideration for closure?

Steve Odland

No. I know everybody would like that. I can’t. We just simply haven’t done it yet. We’ll let you know as soon as we can.

Daniel Binder – Jefferies & Co.

The other comment you made in your formal remarks that struck me as interesting was the I think you said somewhere along the lines that vendors – you had some increased vendor support. And in light of the significant inventory declines and the liquidity concerns out there, warranted or not, it was interesting to hear that vendors were perhaps even incrementally more supportive. I was wondering if you could speak to that a little bit?

Carl Rubin

In terms of liquidity, our vendors have not expressed any concern. We’re getting shipped product without any interruption and any hesitation. As we’ve talked about before, vendor support is an ongoing negotiation that we have with our vendors to support all of our businesses, whether it’s retail, BSD or international. And it’s a tough time for the Office Depot sales. It’s also a tough time for our vendors. So in the third quarter we were able to do some incremental opportunities to help out both BSD especially as well as retail.

So it’s us sitting down with our vendors and really trying to work as aggressively as we can to try to create transactions and traffic and sales opportunities.

Mike Newman

I’d add to that vendor program support as a percent of sales year-over-year is almost identical and it has not appreciably changed in the quarter. It’s the same.

Daniel Binder – Jefferies & Co.

Was there any kind of inflationary buy in activity that helped the margins? If so, how much?

Carl Rubin

Buy in on product you mean?

Daniel Binder – Jefferies & Co.

Yes ahead of pricing increases.

Carl Rubin

Not anything material. We had a little bit of odds and ends. Nothing material. Again our inventory was down significantly from a retail standpoint, North America where most of our inventory is, first our inventories were down 15%. So I mean that indicates there wasn’t a lot of load in of any inventory. We’re managing that inventory really closely to be sure that we’re not stuck with lots of problems going forward.

Daniel Binder – Jefferies & Co.

On the delivery business what is your exposure to the financial institutions? Is it 10% of your delivery business? 20 or more?

Mike Newman

Yes Dan we haven’t talked specific figures but I would characterize it this way that we – it’s one of the areas that we’ve been fortunate from the standpoint that our customer base has been a majority of those that are surviving the current process. It will have some minimal impact but we don’t believe any impact at this point will be material in any fashion.

Steve Odland

Okay. We have one more question. Brian or not?

Brian Turcotte

No.

Steve Odland

It looks like we are out of time. Let me just wrap up by thanking everybody for attendance this morning. Clearly again we are disappointed with our share price and we hope that through our comments this morning we have reassured people on our liquidity situation. Free cash flow was

$195 million this quarter or $0.71 a share. Cash on the balance sheet is $1.44 a share. We’ve got

$1.150 billion in liquidity and the ability to add debt beyond that if we needed to. We’re looking at sale lease back opportunities and other things to be cautious.

We will go through this asset review in the quarter. We are obviously very disappointed in our sales and our issue is our sales. Our sales are dependent on our customers’ financial health and their business health and we will do everything we can to do the right thing in terms of trying to generate profitable sales while not chasing unprofitable sales during this period of time. But we are focused on liquidity. We believe our liquidity is strong and will very much enable us to weather this economic storm. Thanks very much for joining us today.

Operator

Thank you. And this does conclude today’s conference. Thank you for your participation. At this time you may disconnect your lines.

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