Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Staples, Inc. (NASDAQ:SPLS)

F1Q06 Earnings Conference Call

May 16, 2006 8:00 a.m. EST

Executives

Laurel Lefebvre - VP, IR

Ron Sargent - Chairman, CEO

Mike Miles - President, COO

John Mahoney - VP, CFO

Demos Parneros - President U.S. Superstores

Joe Doody - President Staples NAD

Analysts

Danielle Fox - Merrill Lynch

Matthew Fassler - Goldman Sachs

Brian Nagel - UBS

Michael Baker - Deutsche Bank

Colin McGranahan - Bernstein

Chris Horvers - Bear Stearns

Mark Rowen - Prudential

Joe Feldman - TAG

Dan Binder - Buckingham Research

Brad Thomas - Lehman Brothers

Tracy Pai - Citigroup

Presentation

Operator

Good day, ladies and gentlemen. Welcome to the first quarter 2006 Staples Inc. earnings conference call. (Operator Instructions) At this time I will now turn the presentation over to Ms. Laurel Lefebvre, Vice President of Investor Relations. Please proceed, ma'am.

Laurel Lefebvre

Thank you. Good morning, everyone, and thanks for joining us for our first quarter 2006 earnings announcement. During today's call we'll discuss some non-GAAP metrics, such as return on net assets, to provide investors with useful information about our financial performance. Please see the financial measures section of the Investor Relations portion of Staples.com for an explanation and reconciliation of such measures and other calculations of financial measures that we use to analyze our business.

I'd also like to remind you that certain information contained in this call constitutes forward-looking statements for purposes of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by such forward-looking statements as a result of various important factors, including those discussed or referenced under the heading risk factors and elsewhere in Staples' latest 10-Q filed this morning.

I'd also like to remind you that we have restated our 2005 results to reflect the impact of expensing stock-based compensation and will refer to those restated numbers when comparing our 2006 results to the prior year.

Here to discuss Staples' first-quarter results and business outlook are Ron Sargent, Chairman and Chief Executive Officer; Mike Miles, President and Chief Operating Officer; and John Mahoney, Vice President and Chief Financial Officer. Also joining us are Demos Parneros, President of U.S. stores; and Joe Doody, President of North American Delivery.

Ron Sargent

Thanks, Laurel, and good morning, everybody. I'm pleased to announce a solid start to 2006 as our first quarter performance shows continued progress on our strategic initiatives, improving execution in Europe, and our commitment to driving profitable growth. Let's first take a look at the headlines for the quarter starting with the top line which continues to lead the industry.

Total sales were up 9% to $4.2 billion. Our North American delivery business was a strong out-performer again this quarter, growing the top line at 17% and that's on top of 17% growth last year. North American retail sales were up 7%. Our 1% comp was a bit disappointing, but on top of a 4% comp last year, the two-year trend remains healthy.

We were pleased to see continued positive retail traffic and solid comps in our four supplies categories coupled with strong gross margin comps. International results were encouraging with the top line growing 6% in local currency, although sales were down 1% in U.S. dollars.

Our bottom line performance was very strong across all of our businesses. Overall, net income was up 26% to $186 million and earnings per share grew 25% to $0.25. Total company operating margin improved 79 basis points to 6.7% with all business units growing profits much faster than sales.

Inventory turns were up 15 basis points to 5.8 times as we continue to improve our supply chain in all channels.

We generated $54 million of free cash flow after $115 million in CapEx during the quarter. Return on net assets was up 60 basis points to 13%. Customer service was another bright spot with solid improvements in all channels, particularly in our international segment.

Before I ask Mike to talk about our results in each business unit I'd like to quickly review our three 2006 companywide objectives for you. As you've heard before, we're focused on growing our business profitably through industry-leading execution, by building a differentiated brand, and growing our market share around the world. Delivering on these three pillars ultimately leads to superior financial returns.

Let me mention a couple of the big ideas in each of these three areas. Starting with best execution, at Staples this means delivering industry-leading service levels at the lowest cost. Initiatives here include improving our European results; extending supply chain disciplines across all business units; increasing our global buying and direct sourcing efforts; and driving process improvements to take cost out.

The second pillar, differentiating our brand. It's all about driving our own brand program; reinforcing our Easy brand promise in everything we do; and improving customer satisfaction across the board. Innovation will be a common thread here as we look to our team to develop new products and services to make it easy for our customers.

The third pillar is growing our leadership position in markets where we compete. Here our goals are to open additional new markets like Chicago; to open all new stores with even higher sales productivity; and to build a strong foundation for growth in emerging markets like China and South America.

So, we've got a lot going on to drive our results in 2006. The good news is we're off to a very strong start in Q1, thanks to our 69,000 associates who are committed to delivering the numbers and improving the customer's experience day after day. With that I'll turn it over to Mike to discuss our North American businesses.

Mike Miles

Thanks, Ron. Good morning. Our North American retail team delivered another quarter of solid financial results. Sales were $2.3 billion, up 7% versus Q1 last year. Same-store sales grew 1% on top of last year's 4%, reflecting positive customer traffic offset by lower average order size. The reduction in average ticket is primarily due to weak sales in technology, furniture and business software.

Our continuing focus on profitable growth drove gross margin comps of 3% as we continue to successfully implement our strategy to emphasize key supplies and services categories, driving strong customer traffic with our ink and copy center initiative.

During tax season we saw strong growth in office supply consumables like binders and filing while continuing to grow portable computers, drives, networking and computer accessories. We continue to gain share in the ink category. We make it easy for customers to recycle and save by offering a $3.00 coupon for empty ink cartridges. This coupon combined with a broad assortment, including a great Staples' brand offering, drove strong comp growth in this category.

Double-digit sales growth in our copy centers also contributed to the comp. This strength in services and core office products helped the product mix significantly this quarter.

We're executing plans to maximize the sales transfer from the 60 or so OfficeMax stores that recently closed in our markets. After some expected disruption to our sales during their liquidation process, we're now beginning to see a nice sales lift and positive loyalty program sign-ups in these trade areas.

For the first quarter, North American retail SBU income increased by 16% to $180 million. Operating margin increased by 60 basis points to 7.8% with improvements in gross margin primarily due to product mix and good G&A expense control, offsetting investments in marketing to grow our copy and print businesses.

During Q1 we opened two new stores in the U.S. and three in Canada for a total of 1,527 North American stores at the end of the quarter. We're on plan to open 100 stores in North America in 2006. We also remodeled 13 stores to the Dover format during the quarter and now operate 571 new or remodeled Dover format stores.

Our copy center growth initiative continues to gain momentum. During the quarter we continued the national marketing program launched in the third quarter of 2005 that drives initial trial and awareness. We completed our rollout of web submission during Q1 and today can compete with anyone in terms of the breadth of services and technology capabilities we offer. We expect to continue to see huge growth in our copy centers this year driven by people, technology and marketing programs.

We're continuing to expand our partnerships with supermarkets where we offer consumers an assortment of national brands along with a broad selection of Staples brand office supplies. As of the end of Q1 more than 1,000 supermarkets feature a Staples branded aisle and we're now in the process of adding several hundred more Ahold and Bond's grocery stores to the portfolio.

In summary, our North American retail team continues to execute very well, improving [inaudible] and getting good results from our key growth initiatives. We have work to do to push same-store sales a bit higher throughout the remainder of the year through better performance in key categories like furniture, but we're pleased with customer traffic trends and our continued improvement in customer satisfaction metrics and are also making good progress with management and associate turnover, all of which should support profitable sales growth going forward.

Moving on to our North American delivery business, sales increased 17% to $1.4 billion maintaining NAD's impressive momentum. SBU income of $130 million or 9.4% of sales increased 25% versus last year's first quarter. The delivery business' success with acquiring new accounts as well as increasing share of wallet with existing customers drove solid sales growth across all product categories.

NAD posted strong customer satisfaction scores and achieved associate turnover metrics better than plan. Worldwide eCommerce sales in the first quarter were $1.1 billion, a 26% increase year-over-year. Electronic orders continue to grow reaching 88% of orders in the contract segment. Overall North American delivery online sales for Q1 was 71% compared to 65% a year ago.

Staples Business Delivery continued its momentum with solid sales and profit improvement in both the U.S. and Canada. SBD saw particular strength in such key categories as cartridges, furniture, and janitorial supplies.

Our contract business was our fastest-growing segment again this quarter and it continues to acquire new accounts rapidly while delivering the best profit improvement in NAD.

In the first quarter paper mills put through two cost increases, which our team has done a great job managing, but we do anticipate paper costs to continue to put pressure on gross margins throughout the rest of the year with another price increase on the horizon.

Going forward, we see continued opportunity for growth with a focus on several high potential categories including cleaning and breakroom supplies, furniture, technology solutions, and copy and print services for our contract customers.

Quill delivered another strong quarter. Investments and new account acquisition are paying off and retention rates are improving. Quill remains focused on gaining market share and delivering great customer service with sales from new account acquisition exceeding expectations.

To update you on our North American delivery infrastructure, we previously announced plans to open three new fulfillment centers in the U.S. this year to replace five existing buildings, while also adding a new facility in Halifax. One of these new FCs in Atlanta has just opened and is operating smoothly, so we're continuing to expand our multi-channel delivery capabilities to support our rapid growth in North American delivery.

Our supply chain initiatives and our delivery business are also progressing well as we remain focused on improving inventory efficiency and service levels. Over the past year, we've made significant progress on inventory productivity, driving our trips per order metric to all-time lows, and turning inventory faster; all while improving customer service as measured by our perfect order metric.

In summary, our North American delivery business remains well positioned to continue strong top line momentum while delivering margin improvement and delivering on our brand promise to make it Easy for our customers. With that, I'll turn it back over to Ron to talk about international.

Ron Sargent

Thanks, Mike. I'm very pleased with the progress we're making in our international segment. Sales for the first quarter were $544 million, that's up 6% in local currencies, excluding a $40 million negative foreign exchange impact. In U.S. dollars sales declined 1% versus Q1 of last year; profit improvement was very strong with SBU income tripling to $10.5 million compared to $3.5 million for the same quarter last year, as we've really focused on execution as we cycle investments in Q1 of last year. SBU margin increased 130 basis points to 1.9%.

In retail we delivered a solid profit improvement amid slightly positive comps and we're pleased to see strong positive comps in all countries with the exception of the UK. Although comps remain negative in the UK mainly due to weak customer traffic and softness in PCs and laptops, we're nonetheless encouraged by the progress we're making.

Store standards and the customer experience have improved significantly in the UK. Germany continues to perform well and we're working on some new ideas to drive productivity including rolling out a copy center concept to all stores. Throughout Europe we're focusing on driving own brand penetration higher this year. In terms of store growth, we ended the quarter with a total of 259 stores in Europe opening one new store in Portugal.

On the delivery side, both sales growth in local currency and operating margin rate improved year-over-year. Online sales are growing rapidly as we've improved the content and presentation of our products on our websites as well as creating better navigation for our customers. Internet penetration is up over 500 basis points year-over-year as a result of these initiatives.

Our renewed focus on core categories such as paper and ink is also paying off with strong double-digit growth in France. Our new loyalty program is now fully rolled out and is receiving positive customer response.

Finally, we've also begun to roll out new packaging for our Quill brand in Europe to better reflect the high quality of these products.

China and South America continue to grow rapidly. We remain committed to building a strong position in these markets to provide meaningful growth several years down the road.

We feel good about the progress we're making across the board in our international segment. We're confident that the opportunity here is great and the investments that we've made and our focus on execution will translate into continued margin expansion, but we also recognize that we still have a lot of work to do to achieve the kind of performance we're looking for in our international business.

Now I'd like to turn it over to John Mahoney to give you a detailed look at the numbers.

John Mahoney

Thanks, Ron. As I begin I'd like to remind you that beginning this quarter we're expensing stock options under FAS 123-R. As you know, we've restated our quarterly and full year results for 2005 to include the impact of stock compensation to provide comparability. Stock compensation expense impacts gross profit, operating and selling and primarily G&A expense in the P&L. Restated numbers including by segment are available in the financial measures section of our Investor Relations website.

Now, turning to the P&L for the first quarter of 2006. Q1 revenues of $4.24 billion were up 8.7% versus last year's first quarter. With the Canadian dollar helping us and the euro hurting us, currency overall wasn't a big impact in the quarter, only about 15 basis points, so local currency growth was 8.8%.

During the first quarter, gross profit margin improved by 83 basis points to 28.1%. Gross margins were up in all three business units and particularly strong in North American retail, helped by a better product mix with good growth in supplies and services.

For the first quarter, operating and selling expenses deleveraged 17 basis points to 16.9% versus last year's first quarter. This primarily reflects higher marketing and advertising expenses in North American retail as we continue to invest in key growth platforms. This more than offset operating and selling leverage in our North American delivery and international segments, both of which benefited from improved marketing efficiency.

Turning to G&A expense, G&A for the first quarter leveraged 11 basis points to 4.3% of sales as we continue to control all aspects of G&A.

Moving now to the balance sheet, we've continued to manage inventory effectively. Total inventory turns were up 15 basis points versus last year to 5.8 times as we continue to benefit from supply chain initiatives. Inventory turns for both retail and delivery improved as we worked to increase inventory productivity.

Return on net assets for the year improved to 13.0%, that's up 130 basis points compared to the end of the first quarter a year ago. I'll remind you that we've restated RONA to reflect the impact of stock-based compensation to provide metrics on a consistent basis. We expect to drive RONA to our 13.7% target this year which is 200 basis points above our long-term cost of capital.

To recap our liquidity and financial resources at the end of the first quarter, Staples had $2.2 billion in liquidity including cash and short-term investments of $1.4 billion and available credit of about $800 million. During the quarter rating agency Fitch upgraded its debt rating for Staples to BBB+ with a stable outlook and S&P upgraded Staples' outlook to positive on its BBB flat rating.

During the first quarter we repurchased 6.2 million shares under our 1.5 billion stock buyback program announced last fall, leaving about 1.2 billion under this program. We also paid our third annual cash dividend of $0.22 per share during the first quarter, a 32% increase compared to last year's dividend. This represents about $160 million of cash.

CapEx for Q1 was about $115 million, up from the $63 million we spent in Q1 of 2005. With operating cash flow of $168 million, we generated $54 million in free cash flow during the quarter reflecting typical seasonality in our cash flow. Based on about $500 million in planned capital expenditures for the full year, we expect free cash flow generation in the range of $700 million this year.

In terms of our expectations for the second quarter, we expect to achieve earnings per share growth of about 15% to 20%, consistent with current analyst estimates. On the top line we expect low double-digit growth, this implies a low single-digit comp in our North American retail business, mid-teens growth in North American delivery, and flat sales in U.S. dollars and international.

We anticipate that gross profit will be flat versus last year's second quarter and would anticipate a pricing pressure from paper, fuel costs and the Atlanta fulfillment center's start-up costs offsetting margin improvement from own brand, copy centers and supply chain activities. Both operating and selling expense and G&A are expected to leverage slightly. Average shares outstanding are expected to be about 746 million.

In terms of our expectations for full year 2006, in light of the upside achieved in the first quarter, we now expect to be at the high end of the range of 15% to 20% earnings growth guidance we previously provided. We expect low double-digit growth for the total Company on the top line including new store growth in our North American retail store base and a positive low single-digit comp.

For North American delivery we expect to grow revenues in the mid-teens and in international revenue growth could be flattish in U.S. dollars but mid single-digits in local currency.

Thanks for your time this morning, and I will now turn it back to our conference call moderator to line up the Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Danielle Fox, Merrill Lynch.

Danielle Fox - Merrill Lynch

Thanks, good morning. I have a quick question on technology sales. We tend to think of competition as coming mainly from other office superstores, but presumably Dell is a major competitor in PCs and they recently cut prices. I'm wondering what effect, if any, you think that had on your technology sales and what effect it has on your outlook?

Mike Miles

Hi, Danielle, it's Mike. I think the computer market has obviously been very competitive lately but it's one that we have not been a big player in. So Dell's pricing actions are probably not having that big an impact on our business just because we're not that big in computers.

I think we're seeing very strong growth in portable computers in small business for us and desktop computers have been down slightly in the quarter. I think that's probably more reflective of the overall trend in the business than any specific actions that Dell or any of our other retail competitors are taking.

Danielle Fox - Merrill Lynch

I just have a related follow-up question that's maybe just a little bit more philosophical. Given that you had positive traffic trends and that you had very strong gross margin gains from the mix shift, how important is it to reaccelerate the technology and furniture sales, which presumably are lower margin?

Mike Miles

I think we're going to continue to focus on profitable sales growth, but we think that those other categories provide us good customers for attachment sales in the other parts of our business and customers that we want to have in our stores and grow with.

So we want to grow all the parts of the business that we have in our stores and furniture and technology are two of them. Furniture is not unattractive from a margin standpoint and I think that's a business we're looking to restart in the second and third quarter this year.

Danielle Fox - Merrill Lynch

Thanks very much.

Mike Miles

Thanks, Danielle.

Operator

Our next question comes from Matthew Fassler - Goldman Sachs.

Matthew Fassler - Goldman Sachs

Thanks a lot. Two quick questions. First of all, on the overall comp guidance your guidance implies an acceleration of at least 100 basis points in terms of revenue growth from Q1 to Q2. In which business do you feel like you'll see that acceleration, which of the three Staples' business units?

Ron Sargent

I think our guidance, Matt, is low single digit comps for Q2. I guess it depends on how you define low single-digit. But in terms of the growth in our business, we're very happy with what we're seeing with customer count. Categories that look to be growing nicely would include office supplies, ink, copies, copy center, own brand. Those are kind of key categories for us.

In terms of, as Mike mentioned, we expect to see some improved performance in our furniture business. Technology, again, we're going to grow the business profitably and technology will be what it will be.

Matthew Fassler - Goldman Sachs

So furniture and retail would be essentially the driver of the improvement?

Ron Sargent

If you're just talking specifically comp, we're going to continue to ride the horses that Ron mentioned at the outset and the copy center and ink are continuing to deliver good numbers. If you're talking about the business overall, we also have new store growth that is going to be a big part of our sales growth and North American delivery is continuing to accelerate its momentum.

Matthew Fassler - Goldman Sachs

Just focusing on the comp for a moment, is there any change in promotional or competitive stance that you contemplate to drive acceleration in any of those businesses or nothing of that sort?

Mike Miles

Well, we've got some very specific plans in different businesses. I don't want to tip our hand in terms of all of our marketing activities in the next couple quarters, but back to school is coming up, that's a big season for us. I think you'll continue to see us work the ink category which has been strong and, as I say, the copy center business continues to provide a meaningful lift to the overall sales growth of chain.

Matthew Fassler - Goldman Sachs

Got you. Just one follow-up quick question on the financial front. John, your share count inched up sequentially about 2.5 million shares, it was the first time it increased I guess in five or six quarters. Given the buyback and other factors, what's your expectation about share count from here?

John Mahoney

I think, as we saw last year, we expect share count to decline over the course of the entire year. The issue is the number of options that get exercised compared to the value of the buyback. So we buy back in dollars, and as the share price increases we see a lot more option exercises and we actually can buy fewer shares obviously. But I think over the course of the year that will even out and we won't see the share count decline again.

Matthew Fassler - Goldman Sachs

Understood. Thanks so much.

Operator

Our next question comes from Brian Nagel, UBS.

Brian Nagel - UBS

Good morning. A couple questions. First off, with respect to the sales line, could you comment upon the trend in retail comps throughout the quarter? Again, is there anything we can identify that may have impacted the quarter, the sales of these technology-related products?

Ron Sargent

Let me ask Mike to answer the question.

Mike Miles

I don't want to get into specifically what was going on in the quarter. With respect to the categories that were strong and weak, I think we've covered a lot of the specifics of particularly the strong categories. We saw some weakness in furniture, as I say. Business software had some issues from a selling price standpoint as did computer media. Laptop computers for us was down a little bit as that market continues to shift more to portables.

Brian Nagel - UBS

If you had to characterize it, though, would it be more of a macro issue or is it the competitive environment?

Mike Miles

I'm sorry?

Brian Nagel - UBS

If you had to characterize the drivers behind it could you say it would be more macro oriented or would it be more of a competitive environment issue?

Mike Miles

No, I don't think it's macro oriented. I think there are some specific promotional issues in specific categories and it's things that we can get after on a category-by-category basis.

Brian Nagel - UBS

You produced impressive gross margin gains here in the first quarter. Could you comment a little further on the specific drivers there as well?

Mike Miles

Well, if you think about the profitability of the copy center, which is continuing to grow at a rate much higher than the house and has a probability that's about twice the house, that's a big player. Ink and supplies grew more rapidly than the house and I think that's contributing to our gross margin improvement. And own brand continues to grow for us and provide gross margin upsides as it improves its penetration.

Brian Nagel - UBS

Great, thank you.

Operator

Our next question comes from Michael Baker, Deutsche Bank.

Michael Baker - Deutsche Bank

Thanks. A question on the own brand penetration, I think you said that that would be a focus in Europe. Can you just tell us what the overall penetration is? How does that differ in retail versus delivery versus Europe? Where are the big opportunities there?

Mike Miles

I'm not sure I can give you the exact number retail versus delivery, but I can tell you that own brand is growing faster in Europe than it is in the U.S. I think in the U.S. we were at 18% at year end. We expect that to improve a couple hundred basis points this year.

In Europe we're less penetrated so it means we've more room to run and we're growing faster. My guess would be that the delivery mix of own brand would be somewhat higher than the retail mix of own brand.

Michael Baker - Deutsche Bank

Did you talk about an overall goal? Or I think you said the mid-20s is sort of the near-term goal?

Mike Miles

Well, no. We said we're going to get to 20% and then we're going to talk to our customers and see what the appropriate mix is. Because I think at some point customers start to rebel and say, I want to have choice in the store, I want to have national brands in the store. I think we'll do some research at 20% and then make a decision whether it can go higher from there.

Michael Baker - Deutsche Bank

Okay, fair enough. And if I could ask two more quick ones. One, you did mention some of the liquidation sales at OfficeMax had a little bit of an impact. Was that appreciable, did that really have an impact to the overall comp?

Secondly, it looks like you opened very few North American stores, but you still plan on getting to 100. Was there some reason why it was a little bit below that pace in the first quarter?

Ron Sargent

Let me ask Demos Parneros who heads up our retail business to answer those two questions.

Demos Parneros

Hi, Michael. Your first question regarding the OfficeMax closures, obviously they've closed over 100 stores, roughly 60 of those are directly affecting our stores. And the good news for us is that we're making nice headway in those stores. We're seeing a slight comp uptick in our stores. I wouldn't say that it was a material number for this quarter for us, although we expect it to get better as the year gets along.

The other good news for us is that we're getting very positive sign-ups on our loyalty program from those stores. So good news on the OfficeMax closure front. As far as the new stores North America number, we absolutely plan to get to our goal of 100 by the end of the year and it simply the way that we timed and laid out the openings by quarter. So no concerns there.

Michael Baker - Deutsche Bank

Okay, thank you.

Operator

Our next question comes from Colin McGranahan, Bernstein.

Colin McGranahan - Bernstein

Good morning. Two questions. First, I hate to beat the dead horse here, but focusing on retail comps for a second. Mike, you had said you didn't think it was a macro economic issue, but furniture comps clearly were negative here. We saw in March that the small-business economic trends index, which is a sentiment measure for small businesses, it contracted pretty sharply. It was the worst showing since about 2003. It rebounded here in April a little bit, but it looks like small businesses were a little less optimistic. I don't know if that was rate influenced or energy or whatnot. Do you think that showed up? Furniture is a highly discretionary purchase for a small-business.

Mike Miles

Colin, it's Mike again. I suppose it might have had some effect, but based on the strength we saw in core supplies which tends to be a good indicator for us and how strong furniture was in SBD and delivery, it's hard for me to put the blame on anything except our own execution in the furniture category. I think that's something we need to improve on and I think that will have improved results.

Colin McGranahan - Bernstein

Okay.

Ron Sargent

It's a little hard for us to know what's going on with the economy. I can answer that question six months from now, but in real time its hard to know what impact we're seeing from the economy.

Colin McGranahan - Bernstein

Fair enough, Ron. Second question, just on the operating and selling expenses, it delevered about 17 basis points. It sounds like it was largely marketing driven in the retail division. Can you just talk a little bit more about that and how you're going to leverage that going forward? John, if you can also talk about whether that missed your plan because the comps came in below your expectation.

John Mahoney

I think that, as you've seen, our marketing team has done a great job of driving the productivity of our marketing spend over the last several years. We've changed, as we always do, the mix of items that we use. So for example, the coupon for our returning empty inkjet cartridges got a much bigger response than we expected and as a result we had a little bit more expense there. Something that's very healthy for our ink business and is doing a lot to drive the comp in that area.

We also have been very aggressive in promoting the copy center business, which again is a growth part of the business that we expect will gather customers that will have long-term relationships with us and be highly valuable. So I think we're dissatisfied with the overall level of productivity and, as we said, our comp was a little lighter than what we expected.

However, I think that most of the marketing investment was made bodes well for the future that invests in categories that aren't just transactional but really relationship driven.

Colin McGranahan - Bernstein

Thank you.

Operator

Our next question comes from Chris Horvers, Bear Stearns.

Chris Horvers - Bear Stearns

Good morning, everybody. Focusing a little bit on the international division; if you could talk about how the results were in the first quarter versus internal expectations and then layout first quarter, second quarter; how much of the improvement is related to one-time costs from last year? To try to segment out what really the organic growth is on the operating dollar line?

Ron Sargent

Let me take a stab at that. First of all we're seeing good progress in both our retail as well as our delivery business and we're seeing some positive economic indicators that would imply that the European economy is getting a bit better. UK and France which are two largest countries, UK our largest retail and France our largest delivery, they continue to improve and we expect to see a pretty significant turnaround in 2006.

When you look at one-time charges this year versus last year, sometimes it's hard to sort out one-time expenses versus expenses that were associated with poor execution. We've tried to take a look at that. Of the improvement that we saw in the first quarter of 2006, my best guess is that about half were one-time expenses that happened in '05 that weren't repeated in '06, and about half of the improvement was just running the business better.

In terms of where it stacked up versus our plan, basically we were right on our plan for the quarter. Maybe slightly softer than our budget, but our budget was pretty aggressive. When you look at Q2, we expect to make continued progress. Q2 is historically our softest quarter of the year. I think last year in the second quarter we probably lost $10 million to $12 million, but we do expect to see progress from there and we also expect to see progress each quarter throughout the year.

Chris Horvers - Bear Stearns

Okay. So you don't have a good sense of what was one-time in the second quarter last year?

Ron Sargent

Well, I don't want to get into the second quarter because we haven't fine tuned the analysis, but this first quarter was half and half, and I would be looking at something similar to that in the second quarter would be my guess.

Chris Horvers - Bear Stearns

Perfect. And then in thinking about on the private label and direct sourcing opportunity, there was an industry article that quoted an unnamed vendor noting that they could get to 50% of sales. I don't know if it was just a contract delivery guy only or not, and I just was wondering what your thoughts were on reaching such a penetration.

Ron Sargent

You're talking about retail penetration for own brand?

Chris Horvers - Bear Stearns

No. I think the person was more of a delivery company that said it, but still 50%.

Ron Sargent

Probably the best demonstrated practice in the delivery world would be our own Quill business which I think we've been as high as 30%, 31%, 32%. Could somebody get to 50% in the delivery business? Since it is heavily skewed to supplies, I think you can do anything. But again, I think it's customer perception and customer desire and demand and we're letting the customer decide what the penetration is rather than kind of forcing a penetration rate on the customer.

Chris Horvers - Bear Stearns

Perfect. And then one final question. John, in terms of thinking about the comp going forward, is 2% the level on a sustained basis that you need to lever the SG&A and operating expense lines?

John Mahoney

That's always my favorite question because in the long run all costs are variable, in the short run they're all fixed. So I think there isn't really a particularly magic comp point for us. We've got a plan and within certain parameters around our plan we're typically able to manage our costs as variable to try and achieve our earnings objective.

So I don't think within the short run we could talk about any magic level of comp necessary to be able to achieve the G&A leverage. Obviously we're below our plan for our comp this quarter and we leveraged G&A by about 11 basis points. So, if that's helpful to you, that would be an indication, I think.

Chris Horvers - Bear Stearns

Perfect, thank you.

Operator

Our next question comes from Mark Rowen, Prudential.

Mark Rowen - Prudential

Thanks, good morning. A couple of questions. Given the fact that your furniture and computer sales were weaker than you expected in the quarter, do you think you're going to have to take any inventory markdowns this quarter and will that show up in gross margin?

John Mahoney

I think one of the real good news features of our increasing supply chain capabilities is that we have great visibility and the quality of our inventory and when we looked at it at the end of the quarter we found that we had no real risks in our inventory. Our levels of inventory that's discontinued, inactive are right where they've been historically. We don't feel there are any concerns at all about our inventory quality.

Mark Rowen - Prudential

So even in computers where things get obsolete fairly quickly, you're in good shape there?

John Mahoney

That's correct.

Mark Rowen - Prudential

Second, I don't think you disclosed it, but could you give us the comps in Europe for the retail stores?

Ron Sargent

We said slightly positive, so I think it was less than 1 and more than 0.

Mark Rowen - Prudential

Okay. And then on the store openings, you said you're still on track for 100. Does that break out roughly evenly across the next three quarters or is it going to be heavily skewed towards one of the quarters?

Ron Sargent

I think it's going to be skewed towards the second half of the year, probably the third quarter and the fourth quarter will see a lot more stores opening than you'll see in the second.

Mark Rowen - Prudential

Okay. And you said that was by design or did some of the things get delayed from the first part of the year?

Ron Sargent

I think in the first quarter we opened one more store than we expected in terms of our budget. So no, nothing has been delayed.

Mark Rowen - Prudential

Okay, great. Thanks very much.

Operator

Our next question comes from Joe Feldman, TAG.

Joe Feldman - TAG

Good morning, guys. Just wanted to ask a couple questions. First, you mentioned that paper costs are pressuring North American delivery margins and you expect it to continue this year. Can any of that be passed on to the customer or is there anything you can do with that? Also, are there other categories where you're feeling commodity price pressure?

Ron Sargent

Absolutely, paper costs can be passed on. And I'll ask Joe Doody to give you a little more detail on that.

Joe Doody

We certainly can pass it on and have for many of our customers. However, some of the larger customers, there are some contractual commitments that require as to wait a certain amount of time. So there are some delays in that, but we will be passing it on to all customers, it's just a matter of timing.

Joe Feldman - TAG

Got it. Can you provide us with an update on maybe your thoughts on when you might want to look to other new cities similar to the Chicago expansion? It sounds like maybe it's a next year event?

Ron Sargent

Well, Chicago is such a huge market we felt like to do it right we needed a couple of years and we opened 25 stores last year, we'll do 12 to 15 more this year. But yes, our plan is to enter the remaining 10, 11 markets where we don't operate any stores. I think that's part of our strategy of store openings to kind of skew them later in this year, because we are trying to cluster store openings. My guess is we'll have probably more detail to talk about at our analyst day in October.

Joe Feldman - TAG

Thanks. And then one final question just on the UK. When do you guys expect to see a return to the positive comps there? And also, how is the profitability of the UK this quarter?

Ron Sargent

We don't disclose profitability by country just like we don't disclose profitability by business unit here in the U.S. But in terms of the UK, I think we had some work to do to get our stores right for the customer. And I think we've spent the last six months really focusing on the basics of customer service, being in stock, having the stores well presentable. And I think Dick [Neff] and his team in the UK have done a terrific job doing that.

I think you'll see I think us stepping on the gas a little bit with the marketing, something we haven't done for the last six months as we've tried to get our stores right. I think you'll see us stepping on the gas with the marketing probably starting in the second, third quarter. Whether that will generate positive comps in the UK I think it's too early to know.

Joe Feldman - TAG

Thanks. Good luck with the quarter.

Operator

Our next question comes from Daniel Binder, Buckingham Research.

Dan Binder - Buckingham Research

A few questions for you. Delivery just continues to be a rocket and I'm wondering if you can give us a little color on what kind of investments you're making there in terms of sales and infrastructure to continue to drive and support that growth?

Second question relates to a comment that Wal-Mart actually made this morning about worker's opportunity tax credit possibly impacting tax rates if it's not renewed in Q2, just wondering if that would impact you as well?

Thirdly, your international top line guidance I think is mid single-digit, it's a slight change from the mid to high single. I guess given your stepped up marketing later this year and some improvement in the economies, just wondering what might be tempering the expectation there.

Ron Sargent

Let me start from the top; Joe Doody will take the delivery question and then John will take the workers opportunity tax rate question.

Joe Doody

Just as far as the growth of our delivery business, I think we continue to invest in acquisition and our acquisition activities have been extremely successful and the team has found great ways of improving our marketing efficiency to continue to drive new customer acquisition. So that's first and foremost in terms of our ongoing investment in the business.

Also, as we continue to drive the perfect order and get higher levels of customer satisfaction, our retention rates continue to be at record levels, so we continue to hold onto our customers at a very high level.

Third, we've got outstanding programs in all three business units to really drive share of wallet and to improve the share of wallet among all of our existing customers out there. That's why we know that in fact the growth in areas like cleaning and breakroom supplies, which are comping at almost 2X what the overall business is comping at. So tremendous growth in certain areas that we're driving share of wallet. There are many other opportunities to do that over the next several quarters and over the next several years. So we're continuing to invest heavily in all those areas, Dan.

Then the infrastructure, as we noted, we need to continue to keep up with that growth and we've opened up the first of three major centers here in the U.S. In Atlanta that's gone extremely well and we'll follow it in the second and the third quarter with two more openings that will expand our capacity and expand our SKU assortment as well within those facilities. That will help in terms of driving greater margin performance out of those buildings. So those are all the things we're doing to really drive both top line and continue to drive leveraging the bottom line.

John Mahoney

Dan, as far as the worker's opportunity tax credit, it doesn't really have a very material impact on our tax rate and so given the stability in our workforce overall we have lower turnover rates than I think some others do. So we don't expect it will impact our tax rate for the rest of the year.

Ron Sargent

Dan, your third question was guidance for remainder of the year in terms of international. I think certainly the foreign exchange rates are impacting our results. Also we've slowed some of the store growth rates down as we really focused on improving our core business there. Other than that, really not much to say.

Dan Binder - Buckingham Research

Just a couple follow-ups. 1. I was wondering if you can give us an update on the summit supply initiatives and delivery. 2. You made some earlier comments with regard to furniture and technology and some promotional activity maybe there. I'm just wondering if you can give us a sense of what you are seeing on the promotional front. Was it Staples being less promotional than a year ago or competition being more promotional? What do you plan to do to sort of rectify that?

Ron Sargent

Okay. Let me ask Joe again to give you a debrief on the summit supply chain efforts and delivery.

Joe Doody

Dan, we really are going to be leveraging the success of the retail summit program and we're just really beginning to roll out some programs that really will significantly improve our inventory and our fulfillment center productivity.

So for example, a couple of the areas that we're focused on, one is on the import side. We're going to continue to increase the amount of direct sourcing fueled by our aggressive growth of Staples brand. Therefore we've got to make sure we've got a more efficient import strategy in place to deliver to our customers within NAD as well as benefit North American retail.

The other is inventory synchronization in our FC space, and that's to really better synchronize our inbound activities from our vendors to minimize our holdings in our fulfillment centers and really improve our churn rate. Also, allow us to really get more life out of our existing infrastructure.

So those are just two of the programs that we have launched and we'll be launching additional ones here throughout this rest of this year and into next year.

Ron Sargent

Dan, on your second question, I think we saw different things going on between tech and furniture. Furniture, the category in retail, was just relatively slow for us from a unit standpoint. In tech it was more of an average selling price issue driven primarily by some of the ways the vendors were promoting their products this quarter and the impact that had on our net price. It was not an irrational pricing by any stretch of the imagination, just a shift in some of their promotional strategies that drove our average order value down in that segment of our business.

Dan Binder - Buckingham Research

So were units in technology better than the actual comp sales? Am I hearing that right?

Ron Sargent

It's hard to go category by category and break it out; but yes, I would say in furniture the issue was more of the unit concern for us and in technology it was more of an average selling price issue.

Dan Binder - Buckingham Research

Okay. Going forward are there any specific furniture programs that you think you'll run to try and get that going? And on the tech side, are you expecting any other surprises out of the vendor programs?

Ron Sargent

We obviously have aggressive plans in place and are developing others in the furniture area. Every quarter brings new developments in technology, but we think we've got a pretty good handle on that category as well going forward.

Dan Binder - Buckingham Research

Great, thanks.

Operator

Our next question comes from Brad Thomas, Lehman Brothers.

Brad Thomas - Lehman Brothers

Thank you. Just one quick question on gross margin if I may. John, you talked about gross margin being flat in the second quarter impacted by paper, gas and the Atlanta fulfillment center. Could you quantify what kind of a headwind it is that you're up against in the second quarter and then maybe talk about what your outlook is for margin for the second half of the year?

John Mahoney

Sure. Well, I think you saw the level of improvement that we had in the first quarter in our gross margin. We talked about that being driven by our supply chain initiatives, further penetration by own brand. I think that what we're seeing is that in the second quarter we expect that the price increases we've seen in paper are going to be stubborn to pass along.

Gas costs have continued to be a challenge. We've done a great job of managing that through our transportation and logistics team. We expect that that will continue, but they will offset the improvements we're seeing in other parts of the supply chain.

So I don't think we're seeing any extremes headwinds. I think we're just seeing that some of the great results that we saw in the first quarter may not be as achievable in the second quarter with some of those headwinds that you described.

Throughout the rest of the year we're expecting that, as we've seen gross margin improvement over the last couple of years, we'll see gross margin improvement for the full year as well.

Brad Thomas - Lehman Brothers

Just one with follow-up on the international segment. First of all, are you seeing any changes in terms of the competitive environment there? And then also any comments maybe you could make on how the converted OfficeWorld stores are doing versus some of the more core Staples stores?

Ron Sargent

Sure. In terms of the competitive environment, I don't think the competitive environment has really changed much in either our retail business or our delivery business. So not much to report there.

In terms of the OfficeWorld stores, I think as the year progresses we'll continue to add those to the comp base. Just to make sure everybody remembers, we don't include OfficeWorld stores that have been converting until a year after they converted. So in the second quarter I think only about 10 or 12 of the OfficeWorld stores were in the comp base. But what we are seeing is that those stores continue to perform better than our Staples stores and we expect that should have a good impact on our UK results in the second half.

Brad Thomas - Lehman Brothers

Okay, great. Thanks, Ron.

Operator

Our next question comes from Bill Sims, Citigroup.

Tracy Pai - Citigroup

This is actually Tracy Pai on behalf of Bill Sims. My question relates to your global buying and direct sourcing initiative. Could you give us an update on your progress on this front so far this year? Specifically, how soon do you expect to see buying efficiencies from the expansion of your sourcing office in Shenzhen? Have these benefits been included in your '06 guidance? Thank you.

Ron Sargent

Sure, I'll take a stab and then ask John to kind of weigh in as well. You asked when we start seeing the impact of the buying office. I think we've been seeing the impact of the buying office over the last year as we've, one, opened an office and now we're fully staffing it and we're continuing to grow there. Right now direct sourcing is only about 5% of our total sales. So we think we've got a big opportunity to improve direct sourcing in our own brand which is 18% at the end of last year. So we think we've got a lot of opportunity to direct source that. But we also think we've got some opportunity to work with our vendors to do some direct sourcing activities with them as well.

So is it in our guidance for '06? The answer is, yes. And in terms of the percentage or the amount that's in our guidance, I don't have the faintest idea. I think even if I knew I'm not sure I would give it to you, but we do have merchandising margin improvement baked into the plan and a portion of that improvement is due to direct sourcing activities.

So I think that's the last question. Just to wrap up: with a healthy economy, with solid execution and improving traffic in our North American retail business, with terrific momentum in the North American delivery, and Europe on track for a major turnaround this year, we at Staples are confident that 2006 is shaping up to be another strong year of sales and earnings growth.

This month Staples is celebrating our 20th anniversary. As we look back with pride on all that we've accomplished over the last 20 years -- the business that we've built, the people we've developed, the communities we've supported and importantly to the people on this call the shareholder value that we've created over the last 20 years. We're even more excited about what lies ahead for the next 20 years. Thanks, everybody, for joining us today. We appreciate your time and your interest.

Operator

Thank you for your participation in today's conference, ladies and gentlemen. All parties may now disconnect. Enjoy your day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Staples, Inc. F1Q06 (Qtr ended Apr 29, 2006) Earnings Conference Call Transcript (SPLS)
This Transcript
All Transcripts