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Executives

Sam Duncan – Chairman, President & CEO

Sam Martin – EVP & COO

Deb O'Connor – SVP, Finance & Chief Accounting Officer

Analysts

Matthew Fassler – Goldman Sachs

Mike Baker – Deutsche Bank

Stephen Chick – FBR

Oliver Wintermantel – Morgan Stanley

Gary Balter – Credit Suisse

Chris Horvers – JPMorgan

OfficeMax Inc. (OMX) Q3 2008 Earnings Call Transcript November 6, 2008 8:00 AM ET

Operator

Good morning. My name is Katina and I will be your conference facilitator today. At this time, I would like to welcome everyone to the OfficeMax Third Quarter 2008 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. (Operator instructions) Today's conference call will be archived on the OfficeMax website for one year following the call. Note that this call may not be rebroadcast without prior written consent from OfficeMax.

Certain statements made on this call and other written or oral statements made by or on behalf of the company constitute forward-looking statements within the meaning of the federal securities laws, including statements regarding the company's future performance, as well as management's expectations, beliefs, intentions, plans, estimates or projections relating to the future. Management believes that these forward-looking statements are reasonable. However, the company cannot guarantee that the impact of the Lehman bankruptcy on the company will be limited to the amount described in the release, that future events will not impact the company's access to cash or the funds available under its revolving credit facility, it will successfully execute its turnaround plans or that its actual results will be consistent with forward-looking statements, and you should not place undue reliance on them.

These statements are based on current expectations and speak only as of the date they are made. The company undertakes no obligation to publicly update or revise any forward-looking statement whether as a result of future events, new information or otherwise. Important factors regarding the company, which may cause results to differ from expectations, are included in the company's Annual Report on Form 10-K for the year ended December 29, 2007 under Item 1A, Risk Factors and in the company's other filings with the SEC.

It is now my pleasure to turn the call over to Sam Duncan, Chairman and CEO of OfficeMax. Mr. Duncan, you may begin your conference.

Sam Duncan

Thanks and good morning everyone. On today's call, I'll review our third quarter 2008 performance. Sam Martin, our Chief Operating Officer, will detail our operating segment performance and Deb O'Connor, our Chief Accounting Officer, will review financial details.

Now turning to our third quarter 2008 performance, OfficeMax, like other US businesses, operated in a weaker selling environment than in the third quarter of last year, both for our retail and contract segments. Our top line sales results reflect weaker demand trends compared to last year, along with our own deliberate focus on profitable sales and contracts and are pursued with appropriate promotional strategies at retail.

For the third quarter of 2008, total sales declined 9.5%. We recorded an operating loss of $681.5 million and a net loss of $432.7 million or $5.70 per diluted share. Third-quarter results included impairment charges related to the Lehman guaranteed portion of the Timber notes receivable. Excluding these impairment items, adjusted operating income was $54.3 million or 2.6% of sales, and adjusted net income was $28 million or $0.36 per diluted share.

Deb will cover the details of the Lehman note and its accounting, but I want to confirm that, as we indicated in our press release again today, we expect no adverse impact on our operations or liquidity from the Lehman Brothers bankruptcy filing as it relates to our 2004 Timber notes transaction and we believe that any potential cash impact would be funded adequately by excess cash in our credit facility.

In our contract segment, third quarter sales declined and the deleveraging of costs and expenses from lower sales reduced operating margin. In US contract, we experienced decreased sales from our existing customers who are spending less and while we are generating new business, we were not able to drive incremental new customer growth to offset that impact. Since mid-2007, we have refined our customer acquisition and retention approach to ensure that we are providing better service and lower cost, while delivering appropriate profitability for OfficeMax.

Having made these refinements in our US contract, we are pursuing growth opportunities among large and middle-market customers, utilizing our field and inside sales teams. Growth is expected long term as we target contract customer expansion by offering total solutions, helping our customers in these challenging times with effective tools to manage their cost beyond traditional office supplies including furniture, technology and digital print.

We were pleased to announce in early October our alliance with Lyreco, a leading global distributor of office products, operating in 36 countries around the world. While it is obviously very early in our relationship, we are already seeing potential new business being added to our sales funnel.

In retail for the third quarter of 2008, we also experienced sales declines reflecting the challenging economy and expense deleveraging caused a decline in operating margin versus last year. We continued to be prudent in our promotional investment during the quarter to preserve gross margin where possible. On the expense side, a recent retail initiative has been the reorganization of our retail store management launched in June, reducing store management and reallocating payroll to key selling positions. From this initiative, we remain on track to reduce annual store payroll expense by more than the second quarter 2008 charge of $10 million.

In Q3, we opened 17 new domestic stores and five new stores in Mexico to end the quarter at 1,019 total stores. Looking forward, we expect to open just a few more stores in Q4 and we are on track for a total of 40 new domestic store openings in 2008. On store remodels, we made a decision to reduce our 2008 remodel plan to 31 completed as of July to maintain conservative capital management given the weaker economic climate.

Long term for real estate, we continue to believe it is prudent to balance some level of new store openings along with existing store remodels. But, as we plan for 2009 and beyond, we remain cautious with respect to real estate investment given the weak economy. We have not finalized our plan for 2009, but currently we do not plan to have net store growth; meaning our new store openings in targeted locations are expected to be near the level of store closures that we typically have on an annual basis through the lease renewal process or from targeted closures. And at this time, we are not planning additional store remodels until we see more favorable economic conditions.

We are confident that our multi-year turnaround plan initiatives are strengthening our company and better positioning OfficeMax for long-term growth when the external environment does improve. Since the beginning of 2006, we have advanced our infrastructure and operations and we continue to concentrate on key elements of our turnaround plan initiatives. Specific areas of infrastructure and operating improvement that have made significant positive implications are delivery productivity and inventory management. Our supply chain teams have reduced delivery and store fulfillment operating costs, even as fuel costs are up about 50% on a per gallon basis or about $4.5 million in terms of third quarter delivery expense dollars versus last year. And our merchandising and inventory management teams have made prudent purchasing decisions, collaborated with suppliers and enabled efficiencies with inventory productivity this year.

These efforts have translated into lower inventory on a per-store basis, down about 10% at the end of Q3 versus last year, and importantly contributed to an increase in cash flow from operations. We typically target full-year cash flow from operations to exceed capital expenditures and we are on track to accomplish that for 2008. While we are still in our planning process for 2009, that will also be our goal for next year.

Now, I'll turn it over to Sam Martin to review the details of our contracts and retail operating segment performance for the quarter.

Sam Martin

Thanks, Sam. Good morning everyone. For the third quarter of 2008, our contract segment reported operating income of $35.5 million. Contract experienced lower sales and deleveraging of fixed cost of sales and operating expenses for the quarter, but we are pleased with our ability to reduce certain costs in a difficult quarter. Specifically for US contract, which represented 71% of total contract sales, third quarter sales declined 14.6% from the same period last year.

There are a few specific US contract segment trends that I would like to highlight. First, sales from existing customers declined about 8%, reflecting the weaker economy. Existing customers are simply managing their budgets more tightly. Second, sales from new and retained customers decreased in the third quarter of 2008 versus last year, reflecting our disciplined approach to customer acquisition and renewal since mid-2007. And third, our US contract sales in quarter three were impacted by lower sales from our small market public website and catalog business, reflecting again the weaker economy.

During the third quarter, we continued to target sales from higher-margin, middle-market customers while maintaining efforts to pursue profitable, large-market accounts. We have expanded our efforts to generate new large and middle-market sales using more productive selling strategies as opposed to just adding field headcount and by marketing our more flexible delivery model that can adjust to customers' needs.

We are maintaining our centralized pricing decisions and disciplined analytical approach to account evaluation to target more reliable account profitability. Contract gross margin decreased to 21.8% in the third quarter of 2008 from 22.1% last year, due mostly to deleveraged fixed delivery and occupancy costs from lower sales, partially offset by improved account profitability for existing and new customers. While increased diesel costs pressured delivery expenses, we did benefit from targeted efficiencies, including optimizing delivery routes, enabling a 14% reduction in freight cost [ph].

Contract operating expense as a percent of sales in the third quarter of 2008 increased to 18.4% from 17.5% last year, due mostly to deleveraging US contract operating expenses from lower sales. In Q3, we deleveraged fixed marketing, account administration and allocated G&A costs and cycled expense improvements that we began generating last year. These were partially offset by targeted cost controls, including reduced selling expenses and fewer personnel in our customer fulfillment centers. We plan to continue pursuing incremental expense efficiencies going forward in contract to position us for when the economy begins to improve.

Turning now to our retail segment. In the third quarter of 2008, we reported operating income of $29.1 million. In line with factors affecting our performance in the first half of the year, retail results in the third quarter were impacted by deleveraged fixed cost of sales and operating expenses primarily as a result of the weak economy. Our same-store sales decreased 11.1% in the third quarter and we experienced lower store traffic than in the third quarter last year.

For the 2008 back-to-school season, which is always an aggressive pricing environment, we adjusted our advertising strategies to drive traffic in the stores without sacrificing overall gross margin levels, and we continue to rationalize and refine our marketing mix through various media, not just circular advertising. As anticipated, this was a weak back-to-school season with consumers continuing to be cautious. Competition, including discount stores, appeared to extend their back-to-school selling offering later than in prior years. Our same-store sales declined in the third quarter across all three major product categories: Technology which includes ink and toner, supplies which include ImPress sales, and furniture. We experienced the weakest comps for more discretionary, higher-ticket items such as furniture and high-tech merchandise and our average ticket decreased. We also experienced an increase in cherry picking by customers who shopped only promotional items.

Private label as a percent of total sales increased by about 200 basis points in Q3 to 20% in total for retail and in contract, benefiting in part from some new back-to-school products. Recent private label introductions include Ascend mailing products, InFuse presentation products, Canterbury stationery products and expansion of our popular line of DiVoga fashion office products.

Retail segment gross margin in the third quarter of 2008 decreased to 28.5% from 28.9% last year. We benefited from higher merchandise margins in all three major categories and a sales mix shift towards high-margin supplies category sales. But this was more than offset by the deleveraging of fixed occupancy-related costs that has continued since late 2007 for new and existing stores.

Retail store fulfillment costs included in gross margin were impacted by higher fuel costs, but these were mostly offset through improvement programs, including flexible scheduling of store deliveries that enabled fewer miles to be driven. Retail operating expense as a percent of sales in the third quarter of 2008 increased to 25.7% from 24.9% last year, due mostly to deleveraging of fixed operating costs from lower sales in these stores. This was partially offset by targeted cost controls, including reduced store payroll expense in part from the retail store management reorganization we initiated in the second quarter, in addition to the restructuring of the field and ImPress management in the first quarter of this year and from lower incentive compensation expense.

Overall for retail, we expect the improvements that we have made and continue to pursue will benefit us longer term as sales trends eventually cycle and improve. In the fourth quarter of 2008, we expect a weaker holiday selling season than last year and are planning promotional activities to help drive customer traffic while preserving profit margins where possible.

Turning briefly to our retail real estate strategy, as Sam indicated, we are planning significantly fewer store openings in 2009 than we had this year. The store leases we have signed over the last six to eight months have been heavily scrutinized and we believe that the few we plan to open will be solid performers. We expect this very modest store growth to be roughly offset by some store closures as part of our ongoing review.

At this point, I would like to turn the call over to Deb O'Connor, so she can review financial details for the quarter.

Deb O'Connor

Thanks, Sam. I am going to start with a quick review of the P&L. For the third quarter of 2008, we recorded a net loss of $432.7 million or $5.70 per diluted share. This includes a non-cash pretax charge of $735.8 million for the impairment of the Lehman guaranteed installment note and a pretax charge of $18.2 million for impairment of the interest receivables related to that node, neither of which is considered indicative of our core operating activities. Excluding these two items, adjusted net income was $28 million or $0.36 per share. This compares to net income of $49 million or $0.64 per share in the third quarter of 2007.

Adjusted income and earnings per share are non-GAAP financial measures that we use to exclude the effect of the large and unusual impairment charges. I will provide some more specific details related to the Timber note receivables later in my comments.

Consolidated net sales for the quarter decreased by 9.5% to $2.1 billion from $2.3 billion in the third quarter of 2007. Contract segment sales decreased by 11.5% to almost $1.05 billion compared to the third quarter last year, reflecting a 14.6% sales decline in US contracts and a 3.1% sales decrease for the international contract operation. Retail segment sales decreased by 7.3% to $1.05 billion compared to the third quarter of 2007 and that is an 11% decline in same-store sales. We continued to see low double-digit declines in our same location sales for both contract and retail through October and we anticipate similar declines throughout the remainder of the year.

Gross margin in the third quarter was 25.1%, down from last year, reflecting lower gross margins in both the contract and retail segments. Adjusted operating income margin was 2.6% in the third quarter, also down from the prior year.

Operating expense, excluding the impairment charges, continues to show significant deleveraging of fixed expenses from lower sales and new stores, partially offset by targeted cost reductions and $6 million of lower incentive comp expense. The incentive comp expense amount of $6 million is much less than noted in previous quarters as the company reported most of the reduced incentive compensation costs in the first half of the year. Our corporate and other segment spending in the quarter is fairly consistent with prior year levels.

Last year, in the September/October timeframe, the company anticipated the negative sales trends that were eventually realized in the fourth quarter and took the initiative at that time to reduce various costs reflected in operating expenses. These cost reductions continue to be out of our spending base. However, we will have cycled through the favorable impact to our margin comparisons as we enter the fourth quarter. We continue to review our cost structure at the corporate and field level to ensure it is aligned with our reduced volumes, as well as with the reduction of discretionary projects and spending.

Let me cover a few other financial areas and then I will return to a discussion of the timber notes. At the end of the third quarter, we had total debt excluding the Timber securitization notes of $374 million, and cash and cash equivalents of $234.5 million. It is important to note that total debt excludes the $1.47 billion of Timber securitization notes since recourse on the notes is limited to the Timber installment notes receivables. Out of the cash and cash equivalents, we have cash invested and available of $171 million. We also have $602 million of available credit under our $700 million revolver. Our unused borrowing capacity reflects an available borrowing base of $669 million with no outstanding borrowings and $67 million of letters of credit issued under the revolving credit facility as of September 27, 2008.

Another area I would like to cover relates to our frozen pension plans, as well as unfunded retiree medical benefits. At the end of 2007, our unfunded status for all of these plans was $131 million. The pension plans represented approximately $107 million of this amount. The plan's assets, which were approximate $1 billion last year, had been impacted by the recent performance in the credit and equity markets and have experienced significant negative returns year-to-date. Given this market performance, our unfunded status could increase materially from the end of last year, depending on final asset returns and interest rates through the end of the year. However, due to IRF funding policies and our favorable tax funding practices, our 2009 minimum cash contribution is expected to be less than $10 million. And in 2010, we expect to experience significantly higher cash contribution levels. We may elect to contribute more in 2009 in order to reduce the future requirements.

Turning to the cash flow. During the third quarter of 2008, we tightly managed working capital and generated $112 million of cash from operations. We ended the third quarter of 2008 with inventory $7.1 million lower than at the end of the third quarter of 2007, with declines in inventory per store and per distribution center, partially offset by new store growth.

Accounts payable at the end of the third quarter was $23.8 million lower than in the same period last year, primarily reflecting the timing of vendor payments and lower inventory levels. Our accounts payable to inventory leverage ratio declined mostly due to the increase in imports, which require faster settlement terms and higher volumes of safety stock. Receivables at the end of the quarter were $70 million lower than at year-end, reflecting both volume declines in the contract segment, as well as improvements in monitoring and collecting receivables in a tougher economy.

Capital expenditures totaled $36 million for the third quarter of 2008. Based on our review of capital projects, we now expect a lower level of capital expenditures for full-year 2008 in the $140 million to $160 million range. In 2009, we plan to continue to invest cash, capital prudently. While we are currently in the process of budgeting for 2009, we expect a reduced level of capital expenditure compared to the amount spent in 2008. However, we will continue to make strategic investments in areas that will better position us for when the economy recovers.

Now turning to the Timber notes. As we have previously discussed, the Lehman bankruptcy impacts half the Timber installment notes receivable, which were established as part of the 2004 sale of the Timberland assets. As Sam Duncan mentioned at the beginning of this call, OfficeMax continues to believe that the Lehman bankruptcy will not have an adverse impact on our operations or liquidity. The potential cash exposure from the Lehman event of default is expected to be in two areas: First, we expect an approximately $50 million accelerated tax payment related to one-half of the gain on the 2004 sale of our Timberland assets. At the time of our sale, a $543 million tax liability was generated and deferred until 2019, which was the maturity date for the installment notes. Utilizing outstanding alternative minimum tax and other credits, we estimate that the cash tax payment of approximately $50 million will be accelerated to no later than the first quarter of 2009.

Secondly, we expect a loss of net annual interest income of approximately $1 million. Currently, we were expecting approximately $41 million in interest income annually under the Lehman guaranteed installment notes. This interest income funds approximately $40 million in interest payable, which is payable annually to the holders of the related securitization notes. That resulted in net interest income to OfficeMax of approximately $1 million. Non-payment under the installment notes guaranteed by Lehman will result in a loss of this $1 million of annual net interest income.

Now, let me cover the non-cash impairment charge. OfficeMax is required for accounting purposes to assess the carrying value of assets whenever circumstances indicate that a decline in value may have occurred. We have therefore determined the portion of the Timber note receivables relating to Lehman Brothers is impaired and have taken a charge to write it down to its realizable value.

From a legal and economic perspective, the Lehman guaranteed installment note receivables is highly related to the corresponding securitized notes payable and more importantly, the securitized note liability is non-recourse to the company. However, we are required under current accounting rules to continue to recognize the liability related to the Lehman portion of the securitization notes until such time as the liability has been legally extinguished. The company expects that the liability will be extinguished when the Timber installment notes is turned over to and accepted by the securitization noteholders. We expect that this will occur no later than the date when the assets of Lehman are distributed and the bankruptcy is finalized.

As a result, we have incurred pretax non-cash impairment charge of $735.8 million in the third quarter of 2008 and is reported in the corporate and other segment expense, but we do expect to have a corresponding one-time gain in a future period when the securitization note liability is extinguished.

All that said, the maximum estimated [ph] loss to the company upon legal settlement of the securitization notes is expected to be $82.5 million, which is equal to the difference between the principal amount of the installment note guaranteed by Lehman and the aggregate principal amount of the securitization notes.

Interest income was also impacted by the Lehman bankruptcy, as we took a pretax charge of $18.2 million to impair the interest receivable related to the Lehman guaranteed installment note. The interest payment due on October 29 from the Lehman guaranteed installment note was not made and we stopped recording interest income related to the Lehman guaranteed notes. However, we are required under current accounting rules to record interest expense associated with amounts payable under securitized notes liability through the payment default date of October 29, even though we do not expect any future interest payments to be made.

Separately, before I turn the call back over to Sam, I would like to briefly discuss the estimate of the non-cash impairment charge, associated goodwill and other assets that we recorded in the second quarter of 2008. The estimates and assumptions made in the preliminary valuation, as well as our assessments of the charge, were inherently subject to significant uncertainties. As previously indicated, an adjustment to the estimated charge may be required and could be material, but any such adjustment would be a non-cash adjustment. We do remain on track to complete and finalize the amount by the end of 2008. I will now turn the call back to Sam Duncan.

Sam Duncan

Thanks, Deb. We are continuing to execute our multi-year OfficeMax turnaround plan and we remain focused on improving our infrastructure, driving enhanced operating performance and delivering solid financial results. While we are clearly operating in a very different environment today than when we began our turnaround, OfficeMax has made progress and we are pursuing more opportunities for improvement.

Given the expected weak economic outlook, we are cautious in our expectations for the fourth quarter of 2008. We expect significantly reduced sales and like other companies, we anticipate a weak 2008 holiday season. In the fourth quarter of 2008, we will be impacted by two years of declining comp sales and we will cycle significant expense reductions that we generated in Q4 last year.

As a result of these factors on the fourth quarter of 2008, we are currently expecting an increase in the cost and expense deleveraging that we experienced in the first nine months of 2008. So we are taking a realistic approach to our business for the remainder of this year, as well as 2009 given challenging market conditions. We are in the process of completing our financial plan for 2009 and expect to have an update for you early next year regarding our initiatives and goals.

Today, I can tell you we are being conservative in our expectations for 2009, but we are currently confident that our cash position and access to capital are adequate to address the challenges we face from the external environment and to support our turnaround. We are also not standing still. We remain committed to driving differentiation in our product and service offerings and creating cost efficiencies across our businesses that will further improve our productivity. And we plan to continue to manage our business for the long term and over time, to deliver earnings growth, annual cash flow from operations to support investments, and increase shareholder value.

This concludes our prepared remarks and now, we will open up the call for questions.

Question-and-Answer Session

Operator

(Operator instructions)

Sam Duncan

Operator, this is Sam Duncan. Before we get to answering questions, there is one additional item I would like to update all the people on the call, and that is regarding our CFO and Treasurer positions. I want to let everybody know that we have engaged a search firm and the search is going well at this time in looking for the appropriate people. We are moving quickly in trying to fill these positions, but we also want to make sure that we take the necessary time so we don't jeopardize thorough due diligence.

So with all that said, I will tell you I am very confident in the strength of our team that we have in our finance area today, as well as our broader management team. The people that we have in our Treasury position – Will, Carol [ph], Rich and Michael – I am very confident in their abilities and they are doing a great job for us and we will continue to function very well.

I would also like to add that we continue to be comfortable with both the depth and the stability of our overall management team here and we are going to continue to run this company the way that we feel best. And so, as we get more information or we get closer or actually fill in those slots, we will make sure that everybody is aware of that and thank you for your patience. So we will go to the questions now.

Operator

Your first question comes from Matthew Fassler with Goldman Sachs.

Matthew Fassler – Goldman Sachs

Thanks a lot and good morning to you. A couple of questions I would like to ask. The first relates to contract sales. Sam Martin, you gave us some detail on the trend in sales per existing customer, which was down I think 8%. Can you compare that trend to what you had seen in the first half of the year?

Sam Martin

Thanks, Matt. Down 8% is a little more steep of a decline than we had in the first quarter of the year in 2008.

Matthew Fassler – Goldman Sachs

Got you.

Sam Duncan

This is Sam Duncan. On the contract side, it has actually lagged behind the retail as far as the comps worsening, I guess you could say.

Matthew Fassler – Goldman Sachs

Fair enough. The second question relates to retail SG&A. You essentially alluded to the challenge of taking out incremental cost after having been quite disciplined on the cost side for a number of quarters now. By our estimation, the store level or the allocated expenses per store were down around 14% this quarter, which is a peak I guess for this cycle. Do you still think that there is cost that you can take out or are you getting close in your view to some of the minimums at the store level?

Sam Martin

Yes, Matt, this is Sam Martin. Once again, as we look at the business, our retail side, we remain flexible to bring the costs down associated with the operations, appropriate to the level of service we need to provide, appropriate to the level of traffic that is in the stores. And on the G&A side, we are constantly looking at ways to be more efficient and improve our efficiencies. So that would be my answer for you.

Matthew Fassler – Goldman Sachs

Okay, thanks so much.

Operator

Your next question comes from Mike Baker with Deutsche Bank.

Mike Baker – Deutsche Bank

Thank you. A couple of balance sheet-type questions. So one, on the pension funding – I appreciate your insight and comments there. One follow-up question, 2010, you said the cash contribution could be significantly higher. I am wondering if you can put that in context. Are we are talking $50 million, $100 million? Just wondering if you can help us there.

Deb O'Connor

Yes.

Mike Baker – Deutsche Bank

And then I guess the idea is that you would be able to cover that, as well as the $50 million that you might owe in the first quarter from the Timber notes out of your revolver. Is that the right way to think about it?

Deb O'Connor

Yes, that's right. I think we tried to make the point that we do have some excess cash still in the balance sheet as well of $170 million. So between the excess cash and the availability of the revolver, that is where our liquidity would come from.

On the pension question, I guess I would say that the market conditions – our pension plan has taken a beating like everyone else's and we are really currently working with investment managers, trustees, actuaries to kind of set our strategy and understand the future contribution levels that we will be facing. So we need to really see how the market will perform and gain some better insight into that before we would be really ready to talk about total unfunded status today or what those contributions would look like going out a few years. So as we finalize that, I think closer to the end of the year, we will be in a better position to talk more about that.

Mike Baker – Deutsche Bank

Okay, fair enough. One last question. What about the other half of the Timber note situation? Can you remind us who that is backed by and do you see any risk there to a similar type situation?

Deb O'Connor

Yes, that side of the transaction is structured similarly to the Lehman side; meaning it is non-recourse to the company and it has all the same legal and economic status as the Lehman side. So first of all, they are very, very similar. The other side is with Wachovia and I think we all know out there that Wells is acquiring Wachovia – and I know as much as you guys do, but that looks to be a pretty good occasion. So we don't see any problems there right now and we are not anticipating any.

Mike Baker – Deutsche Bank

Okay, thank you. I appreciate that.

Operator

Your next question comes from Stephen Chick with FBR.

Stephen Chick – FBR

Hi, thanks. I guess a couple of questions – maybe for Deb and/or Sam. It is a little confusing that you have to leave the note liability on the balance sheet and if it is in fact non-recourse. So I guess my question is, in your discussions, have you been notified by the holders or their lawyers that they actually disagree with you? And then secondly, can you clarify, is the interest expense – the offsetting $40 million, are you going to stop accruing that in your P&L post-October 29?

Deb O'Connor

Okay, let me start with the last one first just real quick. We will stop accruing for that on the default date, which was October 29. So that is correct.

On the first part of it, we have not been notified by the bondholders or there has not been any sense of anybody disagreeing with our assessment and it is just accounting really right now that has caused this disparity. The structure is still very sound and our understanding of it is very sound, but the way the accounting rules look at it is they want you to look at assets separate from liabilities and basically take an impairment on that asset side, but not to extinguish the debt until at such time it is truly legally extinguished. Meaning we turn over the notes to the trustee. So this, right now, is an interesting case where the accounting does not follow the economics. And that is why it has taken us a while to really get that analysis done because it is a different answer than one might intuitively conclude.

Stephen Chick – FBR

Yes, it is just confusing that you can stop accruing the interest expense and yet you are going to have the liability still hanging out there. It is kind of – I know it maybe sounds like an accounting nuance, but that's what you're saying, is you're going to have to carry this liability on the balance sheet and yet you have no intention of paying it.

Deb O'Connor

That's right.

Stephen Chick – FBR

And you are, in fact, going to stop accruing the interest that is on your books on it.

Deb O'Connor

Right.

Stephen Chick – FBR

Do you have a sense of the timing of when – my understanding is that there aren't any assets that collateralize it, so when you say that Lehman delivers the note to the holders, I don't think there is anything to deliver. I don't think I could be wrong on that, but do you have a sense of when that is going to take place?

Deb O'Connor

Well, the notes would be transferred no later than when the Lehman bankruptcy is resolved. So we are working through that and I think there is all kinds of analysis going on by a lot of different parties. But, right now, our best guess is no later than the bankruptcy – when it is over.

Sam Duncan

Stephen, this is Sam Duncan. We have spent an incredible amount of time on these Timber notes and that is why we delayed our earnings because of that. We have talked to a lot of people, including agencies, regarding this and although everybody looking at this would probably come to the same conclusion that, as you said, why not impair the liability. GAAP says you can't do that and although people have – they sympathize with our feelings and what we are saying, still GAAP says you can't do that. But we have spent – Deb and other people in this company – just a huge amount of time in the past week trying to get some relief from this, but you just can't do it.

Stephen Chick – FBR

Yes, okay, it's an unfortunate set of circumstances here. Okay, and then a second thing if I could – I have a couple more actually. But on your borrowing availability, the $669 million is lower than the face value of the credit facility. And I just want to make sure I understand actually why is that? Is there an assessment of the assets that back the facility and therefore, the borrowing availability is lower?

Deb O'Connor

That's right. And it goes seasonally up and down as well, but it gets based off of the inventory levels primarily that are involved.

Stephen Chick – FBR

Okay. And that is as of the balance sheet date is, I would assume, at the end of September, so as you look forward, does that availability go down in the event that the assets decline because your tangible book value, obviously, has been under pressure too.

Deb O'Connor

Yes. It does move and it does move down. It hasn't moved real significantly over the last four quarters though.

Stephen Chick – FBR

Right, okay. And it is tied primarily to inventory?

Deb O'Connor

It is inventory and (inaudible) working capital.

Stephen Chick – FBR

I am not that familiar with that side of it, but are there any other types of covenants or anything that relate to the borrowing capacity or is it kind of strictly tied to the book value of the assets?

Deb O'Connor

Yes, it is pretty much just tied to that and there is really not many covenants within that agreement. There is a couple of taxes that hit once you get into a really high borrowing rate amount on it, but there is really not much more than that.

Stephen Chick – FBR

Okay. Now another thing, Sam, the potential put option on the Mexican joint venture, I think in your last Q you disclosed it could be $40 million to $45 million if that got put to you. Can you speak to the status of that and is that something that you might have to buy out at some point?

Sam Duncan

We have a great relationship with our joint partners in Mexico. I spend time with them. I will tell you they have not been happier than what they have been in the past three years. The involvement that we commit to them as far as assistance and whatever they need, we are very happy with our relationship with them and we don't even see anything that affects that in the near term or the long term. They are great partners to have.

Stephen Chick – FBR

Okay. But it is puttable to you currently and is that something that you think will have to be exercised and when – is it puttable currently I guess is my question? How does that value change? I guess we will see it in your Q. Do you expect to have to buy it?

Sam Duncan

I answered your question the way I did because it really is a non-issue. We don't see it being an issue. In our opinion, it is not going to happen.

Stephen Chick – FBR

Okay. All right. And then last I guess if I could, can you speak to your dividend? You have kind of a – obviously, the dividend yield on your stock price is very high given the stock price. It's, as far as I can tell, roughly $50 million of cash outflowing annually. You haven't changed it. Depending on how the environment looks, if that is kind of a use of cash that actually would be pretty, possibly given your pension fund and everything else that is going on, might be useful to be up internally for the company. Have you thought about eliminating the dividend at all?

Sam Duncan

I won't make a comment now, Stephen. That is something that the Board – anything like that, our Board always looks at those things, whatever strategic items that may be. We are constantly looking at those and if we decide to do something with that or anything else, we will make sure that everybody is aware of it.

Stephen Chick – FBR

Okay. All right, great. Thank you, Sam.

Operator

Your next question comes from Oliver Wintermantel with Morgan Stanley.

Oliver Wintermantel – Morgan Stanley

Good morning. I was curious about your new relationship with Lyreco. Can you give us a little bit more color about the overall relationship and what you expect this relationship will contribute to your contract business on the top line and margin?

Sam Duncan

I will make some comments first, Oliver, and then I will let Sam Martin make some comments. We are very excited about our strategic alliance with Lyreco and it is a strategic alliance. There is no money changing hands or anything like that. It is strictly a partnership for those global customers out there that might want to have one global partner. We can now do that, where we take care of a global corporation in the United States and they take care of the offices in Europe and other areas. They are in 36 countries. I will tell you they are a very, very impressive organization. Their CEO, Eric Bigeard, has been there for 20 some odd years. They have a management team that has been together for a long time. They are just a top-notch organization that we feel very fortunate to have our relationship with. And as we said in the comments and as I said, we are already seeing some possible opportunities funnel into our company now, with the association that we have with them. But, they are a tremendous organization with great leadership and a great outlet to other parts of the world that we do not have available to us today. And I will let Sam make some comments on that.

Sam Martin

Yes, I would just add that not only is Lyreco a terrific organization and strengthens our global approach, they also are a very tight match to us culturally. So, as we spent more time with them, the methods and the, if you will, the offers that we make to our customers in terms of integrity and how we look at the business are very similar. And so we see a terrific partnership for the long run and certainly feel an instant momentum in our global business sourcing.

Oliver Wintermantel – Morgan Stanley

All of my other questions have been asked. Thank you.

Operator

Your next question comes from Gary Balter with Credit Suisse.

Gary Balter – Credit Suisse

Just one quick question on the press release and then a longer theoretical question, short question. But, you used the wording "the maximum economic loss" to the company when the liability is extinguished is expected to be $82.5 million, which obviously is the difference between the asset and the liability. When we say economic loss, are we just talking accounting loss? Or is that saying since we are never going to be receiving it, we have to call it economic loss?

Deb O'Connor

Right. That is more what it is. Yes, that is exactly right.

Gary Balter – Credit Suisse

Okay, but something that you would have gotten when this whole thing was done in 2019 or whatever.

Deb O'Connor

Right. The $82.5 million was our amount that we would have gotten at the very end that no longer will be coming in.

Gary Balter – Credit Suisse

Okay, so that's it. And then the other question that is frustrating for us because we have a Buy on the stock as it probably is for you, but here is a company where you kind of now explained that the Timber notes is not a liability of the company, so hopefully that is out of the way and you still trade at like three or two times EBITDA. We saw Whole Foods go out and take some equity money investments last night because their view – and they have liquidity issue maybe that you don't have – but their view is they are just not getting respect from Wall Street.

For whatever you can say on the call because, obviously, you are not going to tell us all your strategic direction, how do you think about that in terms of the way your valuation – the way the whole enterprise is being treated by Wall Street and what are the options to get people to appreciate the true value of this company?

Sam Duncan

Well, I am not going to badmouth Wall Street because it is what it is. Would we like for the value to be higher? Of course. There is a lot of companies that are absolutely beaten down, especially retail companies. The problem that we have in our industry, like others, is the items that we sell are fully mostly discretionary. And so consequently, we are going to get beat up in this economic environment that we have today. You look at some of the other companies coming out reporting sales today like Nordstroms, their October business was down 15.7%. Penney's was down 13%. This is companies – we are not an apparel company, but we all sell discretionary items. And in this type of an environment, we're going to get beat down more than others. It is something that we have to look at and we do as a Board, what are the things that we can improve or maybe improve this. And we are constantly looking at that. Of course, we would like it to be higher, but it is not and we've got to do the best job we can.

Gary Balter – Credit Suisse

I will point out Penney's is up 6% today and Nordstrom is up 3.5%. And they also – part of it is – I understand –

Sam Duncan

God bless them for being up.

Gary Balter – Credit Suisse

What is that?

Sam Duncan

God bless them for being up.

Gary Balter – Credit Suisse

No, but I understand the economic cycle, but it seems like there is this permanent dislocation in your valuation versus other companies suffering the same and how does the Board think about that?

Sam Duncan

Well, another thing that affects us, over the time, the Timber notes has caused a shadow over us. My assumption would be that without those Timber notes and that shadow that our valuation – it is only my guess – is our valuation would be higher than it is. It is disappointing to everyone the way it is today and we are going to continue to run this company to try to drive shareholder value. But in this environment, it is very tough. But we are not giving up. We are still doing everything that we can to do that.

Gary Balter – Credit Suisse

Thank you.

Operator

Your next question comes from Chris Horvers with JPMorgan.

Chris Horvers – JPMorgan

Good morning. I wanted to maybe frame out competition in 2009 and particularly on the contract side. Staples acquiring Corporate Express, picks up $8 billion in global sales, about the sales level that you have. So, as you are talking to your vendors this fall and this winter and talking about pricing next year, how do you gain comfort that you will be able to compete in a business that tends to be price driven and given your mantra that you are looking for profitable sales? If Staples can invest in price and you are walking away, where does that leave you at the end?

Sam Duncan

Well, first of all, I will let Sam Martin say something. This is Sam Duncan. We are not walking away from anything. I am not sure quite what you mean by that. But, we are continuing to run this company and Staples made a great acquisition in Corporate Express. I take my hat off to Ron Sargent and his team. But that extra purchasing power is not going to give them the ability where they are like 100% below us on retail or something like that. It does give them more purchasing strength, but it is not – I don't think it is ever going to be to the point where it ruins other companies and we're going to continue to operate and do the things that we need to do to make a profit on the company. Sam?

Sam Martin

Yes, one of the things that has been perhaps a little bit misunderstood about our approach to contract sales is that we have walked away from businesses just because they are unprofitable. That was the case in some particular instances, but overall, we have done a lot of work on our, if you will, cost-to-serve model and we have become more efficient. We are working on efficiencies every day, on how we can do more with less in terms of what we sell and how we deliver it and how it is handled through the process. So there are a number of things that we can still do to become more efficient and the costing isn't significant enough that we won't be competitive, particularly as we look at how we serve and the relationships we build with our contract customers going forward.

Chris Horvers – JPMorgan

I don't necessarily mean walk away. Will you have to, let's say, lower your profitability threshold to remain competitive? Given your view of how much maybe volume or vendor allowance discount that they could get given the increased size, what would be net – does it lower your profitability threshold and how does that balance out versus the supply chain efficiencies and cost-to-serve efficiencies that you have garnered?

Sam Martin

We are not saying that at all. We are not saying that we have to lower our profitability expectations. We have to look at our efficiencies; we have to look at everything we do. And as we go forward and the relationships we build, the total solutions that we offer our customers, we think will remain competitive and continue to be into the future.

Chris Horvers – JPMorgan

Thank you.

Operator

Ladies and gentlemen, at this time, we have reached the end of the allotted time for questions. Mr. Duncan, do you have any closing remarks?

Sam Duncan

No. Thank you, everyone, for joining us today.

Operator

Thank you for participating in today's conference. You may now disconnect.

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