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Staples, Inc. (NASDAQ:SPLS)

Q2 2009 Earnings Call

August 25, 2009 8:00 am ET

Executives

Laurel Lefebvre - Vice President Investor Relations

Ron Sargent - Chairman and Chief Executive Officer

Mike Miles - President and Chief Operating Officer

John Mahoney - Vice Chairman and Chief Financial Officer

Demos Parneros - President U.S. Stores

Joe Doody - President North American Delivery

Analysts

Kate McShane – Citi Investment Research

Brian Nagel – Oppenheimer

Colin McGranahan – Sanford C. Bernstein & Co.

Chris Horvers – JP Morgan

Oliver Wintermantel – Morgan Stanley

Matthew Fassler – Goldman Sachs

Stephen Chick - FBR

Gary Balter – Credit Suisse

Dan Binder – Jefferies

Michael Baker – Deutsche Bank

Operator

Welcome to the second quarter 2009 Staples, Inc. Earnings Conference Call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Ms. Laurel Lefebvre, Vice President of Investor Relations.

Laurel Lefebvre

Good morning everyone and thanks for joining us for our second quarter 2009 earnings announcement. During today’s call, we will discuss some non-GAAP metrics, to provide investors with useful information about our financial performance. Please see the financial measures and other data section of the investor information 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 would also like to remind you that certain information 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

Here to discuss Staples’ Q2 performance and business outlook are Ron Sargent, Chairman and Chief Executive Officer; Mike Miles, President and Chief Operating Officer and John Mahoney, Vice Chairman and Chief Financial Officer. Also joining us are Demos Parneros, President of U.S. Stores and Joe Doody, President of North American Delivery.

Ron?

Ron Sargent

Thanks Laurel and good morning everybody. Thanks for joining us today. I am pleased to announce strong second quarter numbers. We are winning with customers, driving tremendous cash flows and we are delivering solid earnings. We are doing this by sticking to our recession plan; providing great customer service, carefully managing expenses and continuing to invest in growth.

Sales for the second quarter including the results of Corporate Express were up 9% last year to $5.5 billion. Keep in mind our Q2 2008 GAAP results included the impact of Corporate Express for just the month of July. Q2 earnings per share excluding integration and restructuring costs declined 24% from last year to $0.16. Despite lower earnings we achieved record second quarter free cash flow of $184 million.

In early 2008 when we first looked at acquiring Corporate Express we felt the combination of the two businesses would create enormous value for shareholders. We saw big potential for efficiencies in purchasing, supply chain and operations as well as the benefits of expanding our geographic, customer and product reach. Now that we have a full year of integration under our belts we are more confident than ever that this transaction will deliver the value we expected.

I am incredibly proud of how much our team has gotten done in only a year’s time. Just to recap some of the accomplishments, we have combined and trained our sales force with our sales leadership team now made up of half Staples people and half Corporate Express associates. We have developed a cost effective plan to combine our fulfillment center networks. We have made good headway in moving toward a global Staples brand. We are achieving the buying and G&A synergies we planned. We also have been really careful with the planning and execution of the integration to make sure we do the right things for our customers as well as for our associates.

The end result is an excellent customer service and retention, better partnerships with our vendors and a stronger workforce. While we still have a lot of work ahead of us we are right track with our integration plan. I am also particularly pleased with how well our team has kept their eye on the ball. During any integration process, especially one this big, it is easy to get distracted. I would like to thank our associates around the globe for staying focused on customers and working harder than ever to put Staples even further ahead. We have the right plan and the right people in place to position us extremely well for the future.

With that I will turn it over to Mike Miles to talk about our results in North America.

Mike Miles

Thanks Ron. Good morning everybody. Sales for the second quarter in North American delivery were $2.3 billion, an increase of 18%. If you adjust last year’s Q2 sales to include sales from Corporate Express for May and June NAD sales declined 13% in U.S. dollars or 12% in local currency. NAD operating margin declined 87 basis points to 8%. The drivers of the margin decline were similar to what we saw in the first quarter, absorbing the lower margin Corporate Express business, de-leverage of labor expense on softer sales and increased amortization expense.

The mix shift we have been seeing for the past few quarters in our contract business as customer move to lower margin, on-contract products and buy fewer discretionary items, there was a gross margin headwind again in Q2. The team was able to offset these pressures by carefully managing marketing and delivery expense and reaping the benefits of the Corporate Express synergies.

In contract, new customer acquisition and retention were strong. Despite this, sales from existing customers remained negative with top line trends very similar to the first quarter; down in the low double digits. We continue to experience weakness in the more discretionary lines of business. For example, promotional product and furniture were down more than 30% dragging down contract sales by a couple of points.

The contract pricing environment remains competitive and we are seeing instances of aggressive pricing in certain bid situations. Customers continue to respond to our differentiated, lowest cost to serve model. This combined with our significant cost structure advantage positions us very well to win new business and drive higher retention of existing customers while maintaining profit margins.

Staples business delivery and Quill showed sequential improvement again this quarter with top line declines in the high single digits. We did an outstanding job protecting our double digit operating margins in SBD and saw significant improvement in customer acquisition as well as robust operating margin expansion at Quill. These trends support our view that the small business customer segment is recovering ahead of the contract segment where high unemployment will continue to be a factor.

Turning to operational metrics we are doing a great job with customer satisfaction and retention, labor expense management and logistics performance. During the second quarter we further reduced trips per order, increased our perfect order metric and continued to drive efficiency by reducing the percentage of orders under $50. We are making steady progress integrating Corporate Express’ North American operations as we develop a leaner and much more efficient combined organization.

During the second quarter we successfully transitioned all associates in the U.S. to the same payroll system and implemented one compensation plan for all Staples Business Advantage and Staples National Advantage sales associates. We are now developing our 2010 full line catalog with one common product assortment and we have finalized our own brand sourcing and packaging requirements. We also continue to rationalize our transportation network and have begun using the re-branded Corporate Express fleet to deliver Staples orders in a number of U.S. markets.

Moving on to North American retail, sales for the second quarter were $2.0 billion, down about 5% or 3% in local currency versus Q2 2008. Same store sales were down 5% showing continued momentum in the recovery trends we are seeing this year. We are winning in retail by driving traffic into our stores, taking advantage of competitive closures and continuing to grow square footage. We are also increasing productivity by growing services and attachment rates.

Traffic continued to improve and customer comps were down 2% compared to Q2 2008. Average ticket is still accounting for the majority of overall comp decline but it too showed some improvement. Purchases of higher ticket business machines and furniture remain weak. Printers, software, office machines and multi-function devices were especially soft but our key destination categories including ink and paper comped positively.

During the quarter we also saw a very encouraging customer response to our focus on computer solution selling with strong positive comps for both laptop and desktops. The team did an outstanding job managing expenses and despite the fact that Q2 is our lowest sales quarter we were able to protect our operating margin, down only 9 basis points to 5.2%. North American retail has benefited from the purchasing synergies too, driving improvements in product margin rate. We have also tightly managed G&A and distribution expense, helping to offset de-leverage on both the rent and labor lines.

We did a good job managing working capital and reduced inventory per store by 6% compared to last year’s levels. We officially kicked off back-to-school in early July and are off to a good start. Value is top of mind for our customers and this year’s back-to-school plan was designed to be responsive to our customers’ appetite for great deals.

Staples brand products are a great way for customers to get quality products at lower prices and our new marketing campaign, “Staples Equals Savings,” appeals to customers especially when we have hot offers like a ream of paper for $0.01 or a backpack for free after rewards. We are turning our improving traffic into a profitable basket through our broad assortment, excellent customer service and in-store execution. While several weeks of back-to-school are still ahead of us we are pleased with our results so far.

During the past few years our business service offering has become a much more meaningful part of North American retail. We have invested in labor, training and store infrastructure to make sure we have a relevant offering and high quality service. Today services including copy and print, Easy Tech, Warranty and Mail and Ship together make up about 9% of North American retail sales and are about twice as profitable as the house. While we have seen modest negative top line trends in the copy and print business during the past few quarters we have learned a lot from our stand alone copy and print shops we can apply to the whole chain.

This is paying off with our quality assurance process and our ability to use the sales force and customized pricing tools to win large orders and recurring business. Easy Tech services are the fastest growing part of our portfolio and we have dramatically improved our capabilities over the past couple of years. We have made significant investments to raise the awareness and trial of Easy Tech including a free tune up offer for much of this year leading to triple digit growth so far in 2009. We expect our services to continue to grow faster than the house becoming a much bigger percentage of our mix over the next several years.

We continued to invest in store growth in Q2, opening 10 and closing 2 stores in North America and ended the quarter with a total of 1,872 stores. These include our first stores in Tucson, Arizona as well as our 17th and 18th stand alone copy and print shops in the U.S. We expect to open about 50 stores for the full year with 45 in the U.S. and 5 in Canada.

With that I will turn it over to Ron to talk about International.

Ron Sargent

Thanks Mike. While we are pleased with our performance in North America we weren’t as satisfied with the results in International during the quarter. Including the impact of Corporate Express, Q2 sales were $1.2 billion an increase of 21% in U.S. dollars and 32% in local currency compared to the same period last year. If you include sales from Corporate Express in May and June of 2008 our international sales were down 26% in U.S. dollars or 14% in local currency.

Operating margin came in at 0.3% of sales, a decrease of 116 basis points from the same period in 2008. Disappointing results in China, declines in our printing systems business in Europe and increased amortization expense drove the majority of the de-leverage. European contract and catalog margins declined on softer sales while the retail business showed nice operating margin improvement particularly in the U.K. and in Germany.

In contract, similar to what we have seen in North America, customers are buying more of the basic on-contract items and that pressures both sales as well as margins. In both our contract and catalog business we have a high percentage of furniture in the mix and that also weighs on results.

Our European retail business saw strong sequential improvement, reflecting what we have seen in North America with the smallest customers coming back first. Same store sales declined only 3% and we saw positive comps in ink and copy services while technology and furniture remained under pressure.

The retail team did a nice job controlling expenses to increase operating margins year-over-year. We added two new stores in Portugal and closed one of the Corporate Express stores that we acquired in the second quarter with 334 stores in Europe.

While our international results are not where we want them to be, we are encouraged by the progress we have made to build a foundation for a profitable, growing business. First, we are restructuring our European business to become much more efficient. We are pleased with our streamlined regional structure and our discussions with the European Works Council and local employee representatives across Europe are proceeding as planned.

Second, we will soon begin to see the impact of the Corporate Express synergies. The integration work in Europe got started about nine months after we began in North America so we are still working hard on product and non-product buying and those negotiations are going well. We are making nice progress consolidating the contract and catalog back offices and warehouses in Italy. Our re-branding and owned brand initiatives in Europe are also on track. With our improved capability to serve global accounts we have won several new national as well as global customers and the bid pipeline is very healthy.

Third, and most important, we have made several changes to strengthen our leadership team. A few weeks ago Peter Ventress announced his intention to become the CEO of Davis Service Group in the U.K. and on behalf of the Staples team I would like to thank Peter, who is on the call this morning, for his leadership during the past year and wish him great success in his new role.

We have asked Mike Miles, our President and Chief Operating Officer, to assume responsibility for international starting on September 1. Mike’s knowledge of Staples, his leadership and cross channel expertise will be tremendous assets as we drive for the successful integration of Corporate Express, deliver profitable growth and build a strong global Staples brand. Our international business is critical to our future success and Mike’s new assignment reflects our commitment to becoming a global leader.

We have also added new talent to several other areas within International. Rob Vale recently became President of Europe, a new role. Rob brings 20 years of experience in the European office product industry. In addition, Chris [Maddow], who headed up marketing for our Staples Catalog Business in the United States, just relocated to Amsterdam to lead our European marketing team. Pat Hickey, a Staples veteran, has rejoined the company to take on the new role of Chief Operating Officer in China. These organizational moves position us to drive much better top and bottom line growth in international in the quarters ahead.

Now I will turn it over to John to review our financials. John?

John Mahoney

Thanks Ron. Our second quarter GAAP earnings per share on a fully diluted basis declined 38% to $0.13 versus the second quarter 2008. Excluding integration and restructuring expense our adjusted earnings per share declined 24% to $0.16 versus the second quarter of 2008.

Integration and restructuring expense for the quarter was about $30 million primarily related to severance and retention costs. This expense was higher than our Q2 guidance due to timing as our European restructuring efforts are ahead of plan. Our full year guidance for integration and restructuring expense remains unchanged.

As a result of the Corporate Express acquisition net interest expense increased by $45 million and amortization expense grew by $12 million. This reduced EPS by a little more than $0.05. The stronger U.S. dollar continued to drag on both the top and bottom line during Q2. The negative impact to sales was about 320 basis points with the Canadian dollar accounting for about 1/3 of the decline and EPS was reduced by about $0.01.

Gross profit margins decreased by 89 basis points to 25.7%. This decline reflects the combination of the lower margin Corporate Express business and de-leverage of rent expense in North American retail, partially offset by purchasing synergies. SG&A leverage was 52 basis points versus last year’s second quarter to 21.0% of sales. The lower SG&A at Corporate Express as well as reduced marketing spend drove this change. This improvement was somewhat offset by labor expense de-leverage across each of our businesses.

Including the impact of the lower margin Corporate Express business and excluding integration and restructuring expense, adjusted operating income declined 57 basis points for the quarter to $236 million or 4.3%. Capital expenditures came in at $76 million for the second quarter down from the $95 million we spent in Q2 2008 as we continued to invest prudently in growth ideas.

With robust operating cash flow of $260 million for the quarter we generated a record second quarter free cash flow of $184 million. $184 million. Year-to-date we have generated $568 million in free cash flow compared to $19 million during the same period last year. Cash flows have been excellent so far this year and while we expect to generate over $1 billion in free cash flow for the full year the magnitude on the up side will largely depend on working capital performance in the back half of the year.

At the end of Q2 Staples had approximately $1.4 billion in liquidity including cash and cash equivalents of $633 million and available credit of $765 million. To update you on our capital structure, we reduced our debt by $256 million and ended the second quarter with just under $3 billion in total debt. In the 13 months since we acquired Corporate Express we have reduced our debt by about $1.5 billion and we will continue to use our free cash flow to de-lever our balance sheet.

To help you would with a few of the lines on our P&L, we expect depreciation expense to be $105-110 million for the third quarter and $430-440 million for the full year. We anticipate amortization expense to be $24-30 million in the third quarter and $100-110 million for the full year. Integration and restructuring expense is expected to be $20-30 million for the third quarter and $90-110 million for the full year. Net interest expense is expected to be $60-65 million in the third quarter and $235-245 million for the full year. This is consistent with our previous full-year guidance.

We expect the impact from foreign exchange to be neutral during the third quarter assuming rates stay at today’s levels. In terms of share count we expect about 725 million for the third quarter as we are not planning to repurchase shares to offset equity compensation activity.

Finally, we still expect to spend about $350 million in capital for the full year.

Thanks for your time this morning. I will now turn it back over to our conference call moderator for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Kate McShane – Citi Investment Research.

Kate McShane – Citi Investment Research

The sequential improvement in comp store sales especially in Europe was great. I wonder how much you think is from share gains and how much you think is from an improvement in the environment. Also, do you think trends from month to month are consistent enough for you to have confidence that comps are going to sequentially improve going forward?

Ron Sargent

Europe is kind of a little bit of a different animal than the U.S. but it is also similar. It seems like we are coming back about 6-8 months later and it seems like we are coming back about 6-8 months later. The biggest benefit that we had during the quarter was we had easier comparisons in the second quarter of this year versus last year. It is too early for me to say we will see continuing sequential improvements in comps in Europe because I think things are just too choppy and the environment is just too uncertain. I think it is similar to the United States in that we will feel it in retail first, then probably catalog second and contract third. I just think it is a little premature to know about the continuing improvement in the comp side in Europe.

Kate McShane – Citi Investment Research

If I can ask one more question about back-to-school in terms of promotions, are promotions more aggressive in your opinion for this back-to-school season compared to last year? If not, do you expect they will get more aggressive as we move into September?

Demos Parneros

I think back-to-school promotions have been fairly consistent with last year’s level of promotion. Everyone this time of year becomes a back-to-school retailer. There are probably 10-15 different places you can buy back-to-school products. We have been focused, as we said earlier, on whole value messaging and the Staples Equals Savings campaign has been great. I think customers have responded really well to that. As far as the rest of the market we expect similar levels of promotions and competitiveness for the rest of the way. Overall I would say fairly similar to a year ago.

Operator

The next question comes from the line of Brian Nagel – Oppenheimer.

Brian Nagel – Oppenheimer

My first question is with respect to sales. More in the U.S. You did see an indication of sequential improvement in retail comps and while your comparative shows some deceleration, so maybe you could talk about what we actually saw through the quarter so we can get a better idea of where the trends may be heading here?

Ron Sargent

I don’t want to get into the every quarter reporting or monthly comps because we don’t do that. I can tell you it was pretty consistent throughout the quarter. I don’t think there was huge variations. We are feeling like maybe the economy is coming back a bit. We have seen sequential improvement now for the last 3-4 quarters, or 3 quarters. We think that is a good indicator of the future health of our business.

Brian Nagel – Oppenheimer

Mike, you made a comment in your prepared remarks where you talked about more aggressive pricing on the contract side. I just want to be clear, is that something ongoing or is it more of an indication of change and would you say competitively more recently?

Mike Miles

I think the contract space is always very price competitive. I think over the last several quarters we have seen some of our competition really make a concerted effort to win business at any cost. Joe do you want to comment further on that?

Joe Doody

I think most of our competitors are very aggressive out there and they want to make sure they are holding onto their market share. We continue to just drive our lowest cost to serve model to really build sustainable, profitable growth and we continue to see good, new customer acquisitions that we are very satisfied with. Also we are proud of the fact that we have well over 50% of the fortune 100 we are the primary supplier to. So it is competitive. Always has been. Most of our competitors are really trying to hold onto their market share right now.

Operator

The next question comes from the line of Colin McGranahan – Sanford C. Bernstein & Co.

Colin McGranahan – Sanford C. Bernstein & Co.

My first question is for Mike Miles. I guess next Tuesday you assume your new role, Head of International, and I thought maybe broadly you could tell us a little bit about what you think your road map is and your priorities. I was intrigued especially with the comment that the restructuring there looks a little bit ahead of plan. Can you talk specifically around the time line around expense reductions in Europe and working through the work council process? As you move through the purchasing synergies and discussions with vendors what do you think the opportunity there is relative to what you saw in the U.S.?

Mike Miles

Well as Ron said, we weren’t real happy with our international results this quarter but I think we are confident we are on track for improved performance. Peter did a very good job in creating momentum for a single global multi-channel brand and establishing the org structure in Europe that I think will help us achieve the performance up side that we have all said is probably there. From a synergies standpoint we are probably a year behind where we were in the U.S. That is partly because in the U.S. we were putting together basically two businesses that were in the same business and in Europe we are merging a contract business with a retail business with a catalog business which even the Staples businesses weren’t fully integrated there. That coupled with the Works Councils process means we are probably sort of a year behind. The purchasing initiatives are really just getting underway.

I think we have got the right direction internationally. We have strong new leadership in Europe, Australia and in China. I think as I get into it this isn’t about a change in direction, it is really about executing the plans we have in place and I am sure over time we will learn new things. Really I am focused on executing the plans that we have already laid.

Colin McGranahan – Sanford C. Bernstein & Co.

Maybe a follow-up for Ron or John. Fairly impressive expense leverage given some negative double digit declines in delivery and still negative mid single digit comps in retail. The question is how sustainable is this level of expenses? Part of the way you got there was reduced marketing and advertising. If we get towards flattish retail comps sometime in the next few quarters and hopefully the delivery business following in 2010 is flattish, what kind of expense leverage would you expect at that point?

John Mahoney

I think as we said at the beginning of the year, last year we felt as though we really chased expenses down. Therefore, an awful lot of the expenses that are fixed in the short run are very difficult to manage. As we planned this year we really challenged everything and made many of our expenses variable and I think you have to look at both the North American retail and North American deliver team and say they did a terrific job of identifying areas where they can make expenses variable and whether it is distribution and deliver which is leveraged nicely with sales or many of the other more mundane expenses in stores, all of them we have been able to continue to leverage with sales.

I think that is sustainable. I don’t think we are going to see improvement in our operating margin rates at least until sales start to grow because I think we are investing in things like labor and stores and service and delivery to make sure we are giving the customers a great experience so that we can continue to win in the marketplace. So, I think you can expect to see us continue to maintain reasonable operating margin rates even in the face of slow sales. Once sales pick up that is going to give us tremendous upside in terms of operating margin rates as we have really learned an awful lot about our cost structure over this period.

Operator

The next question comes from the line of Chris Horvers – JP Morgan.

Chris Horvers – JP Morgan

I want to focus on the gross margin trend a little bit here. Can you talk about the rate improvement that you saw in the second quarter and perhaps the first half if you excluded the mix impact of Corporate Express?

John Mahoney

I think as was talked about in the U.S. in particular we have really seen the purchasing synergies really begin to make a difference. The mix of products has also been decent for the most part. We have seen a little bit of a pickup in technology sales in the U.S. retail business but that was offset somewhat by the tremendous success we had in growing our services business. Overall, I think the combination of mix and better buying has allowed us to see improvement in gross margin X the CE mix. I think the same thing is true in NAD although the CE mix has a much bigger impact there obviously.

Chris Horvers – JP Morgan

So in terms of basis points is it 100? 200 basis points negative mix impact?

John Mahoney

I think it is difficult to reconcile precisely given the fact that within our NAD business we have really merged in the accounts so that in many cases it is tough to distinguish which accounts are which. We told you very early on we had the sales forces aligned and while some of the larger accounts are still easily identified today the mid market accounts are pretty much homogenized and we don’t really track it by the legacy businesses anymore.

Chris Horvers – JP Morgan

So it sounds like what is driving gross margin up here in the first half of the year is the impact of Corporate Express has some legs as we think about the back half?

John Mahoney

I think that is right. As we have been saying all along from a Corporate Express perspective there is an awful lot of operating expenses that contribute to our gross profit line that will improve. Things like decreasing average order size, improving the efficiency of the distribution and delivery network and I think all of those things will help as well. It is not just about input costs and what we pay the vendor.

Chris Horvers – JP Morgan

On the NAR comp, very nice improvement sequentially. Do you think the biggest delta 2Q versus 1Q was ticket size? How much is that Staples being a better destination for the laptop and PC category versus an economic recovery?

Ron Sargent

The customer count was flat; I think minus two in the first quarter and minus two in the second so really all the pickup is average order value. I am not sure that is necessarily just technology. I think services comped very nicely. Certainly the office supply basics are continuing to grow as well and we had positive comps in many of the key categories such as paper and ink and toner and that sort of thing.

John Mahoney

It is a little hard to talk about, we are not used to negative numbers so as everything comes back…the average order size did decline which was drove the negative comps. Traffic has picked up comparatively speaking. It was flat quarter-over-quarter.

Operator

The next question comes from the line of Oliver Wintermantel – Morgan Stanley

Oliver Wintermantel – Morgan Stanley

Can you give us some more color on what happened throughout the quarter on the contract versus the Staples business delivery business?

Joe Doody

As far as the contract business, it essentially stayed the same sequentially, quarter-over-quarter. If you look at it, last quarter we gave you a little more description on that than we are on an ongoing basis but essentially our new customer sales growth was offset by some lost sales as well as some negatives in our lines of business. So in the end the result of our negative growth in contract is pretty directly a function of lower sales to existing customers. That has essentially stayed the same on a quarter-over-quarter basis here in Q1 and Q2.

SBD and Quill both showed some sequentially some improvement so we are seeing the impact from a little stronger come back in the small customer segment is benefiting them. Still negative but slightly less negative than we saw in Q1.

Oliver Wintermantel – Morgan Stanley

Ron, if you look at your capital structure you continue to pay down debt, what is a level you are comfortable with and when can we expect some share buybacks again?

John Mahoney

We said when we got some of our financial ratios back to near where they were prior to the Corporate Express acquisition we would begin thinking about buying shares back. You would expect that would be in the middle of next year at some point. We have done a nice job of generating the cash necessary to pay down the debt that we can and we still have that opportunity for next year. As we have seen the maturities scheduled out it gives us a nice plan to be able to get our debt paid down fairly quickly. The middle of next year or so we will be in a position where we will be able to begin to buy back shares.

Operator

The next question comes from the line of Matthew Fassler – Goldman Sachs.

Matthew Fassler – Goldman Sachs

First, related to PCs as they relate to retail sales and profitability, can you talk about the magnitude of the sales improvement that came from the increases in PCs and laptops? Also if you can relate them to domestic retail margins and the point on margin being that you did very nicely last year despite the comp decline. It looks like the second quarter structurally speaking with last year being the first time this happened has experienced the biggest year-over-year declines from prior levels of profitability. I am just trying to understand whether PCs actually held them back a little bit in this quarter to the extent they contributed to your sales growth?

Ron Sargent

PC comps were slightly positive. You have good growth in laptop and netbook. You have slow growth in desktops. Demos you might want to refer to this but I will check the number but I think it is maybe mid to high single digits in PCs?

Demos Parneros

With respect to margin obviously they are a drag on margin and the thing we have been focused on is really listening to customers very carefully to make sure we sell them the right PC in the first place so that they stay sold. Really we spoke earlier about services I think tech services at the point of selling the PCs and other services such as warranty plans and then the key accessory items have really helped build a much better, much more profitable basket. With the acceleration with PC sales we have actually gotten much better at it. Obviously it isn’t near the house yet but it is definitely offsetting what it started out to be a pretty unattractive margin in the laptops.

Matthew Fassler – Goldman Sachs

Ron, when you talk about mid to high single digits is that the comp store sales increase for PC’s or is that different?

Ron Sargent

That would be PC comps.

Laurel Lefebvre

A little higher than that in our U.S. business and a little lower than that for the bigger percentage of PCs in mix so it wasn’t as big of a help in Canada. That would be the average for PCs.

Matthew Fassler – Goldman Sachs

Are PCs sort of mid single digit as a percent of sales these days? In terms of mix?

Laurel Lefebvre

About 6%.

Matthew Fassler – Goldman Sachs

So if they are ten points better than the chain a little better than that and 6% of sales I guess 50-60 bips to overall same store sales?

Ron Sargent

Sure if you do the math.

Matthew Fassler – Goldman Sachs

On international, just trying to aggregate what we saw. Is it safe to say that international contract probably lost some ground while the smaller customer businesses, the mid market businesses if you will, showed a bit of improvement similar to the U.S. just to clarify what the contract term is there?

Ron Sargent

It is not just contract but it is the delivery business in Europe I think lost some ground. When you deliver a 3% operating profit it is hard to say that anything looks great in Europe. That is why I think it is up from here. I think retail did make some nice improvement. Retail now is about 30% of the mix. Contract is 35-40% of the mix in Europe. Catalog is about 20% and then the last 10% is the printing division.

Matthew Fassler – Goldman Sachs

A clarification on stock based comp as we look to forecast that I think this is your seasonal peak for stock issuance though it hasn’t always necessarily been the highest quarter. What is your expectation for what that looks like going forward? What are the moving pieces behind that? Is it just issuance? Is it price of the stock? Help us project that number.

John Mahoney

I think it is a couple of things. First of all we do issue our stocks in the middle of the year so that solidifies what we expect for the price of the stock and the amounts that are amortized over the vesting period. In addition to that we do have some variable comp plans which go up and down with the stock price. I think you should expect the seasonal trends we have seen in the past will continue.

Matthew Fassler – Goldman Sachs

So this would probably be the peak but it doesn’t look like historically it has gone down that much, certainly not from Q2 to Q3?

John Mahoney

That’s right.

Operator

The next question comes from the line of Stephen Chick – FBR.

Stephen Chick - FBR

Good luck to Peter on his new company there. I have a couple of numbers related questions. The $300 million of synergies can you give us a sense of how much you think you have garnered of that to date? Secondly, I think we should still be looking for I think 40% of that number being achieved by the end of this year?

Ron Sargent

$300 million is still a good number and 40% in 2009 I think is still a very good number as well. Obviously the 40% of the $120 million is probably more back loaded as our sales are more back loaded. We still expect to see the $120 million.

Stephen Chick - FBR

Do you have a figure of what you think you achieved so far of the $120 million through this quarter?

Ron Sargent

Sure we have that number. I’m not sure we are going to share that number with you. I think $120 million is a good number for the year.

Stephen Chick - FBR

Secondly, with the foreign currency effect on the quarter I have it as about $11 million in operating profit hit so to speak. John do you have what the split of that would be towards retail versus say North American delivery and international?

John Mahoney

Obviously the places where the currency impact in our businesses was in our Canadian retail business and in Europe. We said about 1/3 of it came from the Canadian business. You are $0.01 per share and $11 million I would say 1/3 is Canadian retail and 2/3 is Europe.

Stephen Chick - FBR

Lastly, Ron can you update us on where you stand with rationalizing kind of the distribution centers and the infrastructure first here and what the opportunity of that looks like in international?

Joe Doody

In the U.S. we have a plan developed. Combined we are at a little over 40 fulfillment centers here in North America. We have taken action so far on five of them; three that we have closed down here in the U.S. this year. Two more we have announced we will be shutting down and consolidating between now and the first quarter of next year. We are well on our way. There is a lot of systems work that needs to be done to successfully execute that moving to a common warehouse management system and that will lead to interfaces from our various front ends into that common warehouse management system.

The first facility that we will have going in that direction is set to go live here between now and the end of the year. We will be rolling further consolidations out throughout the next several years. So well on our way but still a lot of work yet to be done.

Ron Sargent

International is really just getting started. We have got a lot of discussions going on right now with Works Councils across Europe to talk to them about the plan. We have made pretty good progress in integration international in general. The synergies are really just starting to kick in on the buying side. Mike talked about creating regional structure. We are well into the vendor negotiations. We took about $10 million out of the headquarters in Amsterdam in the G&A line. We have certainly analyzed our supply chain. We have launched the Staples brand across Europe and we made a decision for the IT platform for Europe. I think we are later because obviously the big dollars were in the U.S. We are later in getting started on the integration in Europe but we are well underway. The key is to work through all the special issues with the Works Councils and we are in the process of doing that as we speak.

Operator

The next question comes from the line of Gary Balter – Credit Suisse.

Gary Balter – Credit Suisse

If we look at North American delivery, a flat quarter and this quarter looks like it was better in terms of comps because you said high single digit declines versus low double, but you didn’t comment on the rate of Staples and Quill. Can you talk about the rates?

Ron Sargent

In terms of sales growth?

Gary Balter – Credit Suisse

In terms of the operating margin.

Ron Sargent

Comparable to last quarter.

John Mahoney

Very strong. Quill is actually slightly improved in the quarter sequentially. SBD has continued to hold its very strong double digit margin rates.

Gary Balter – Credit Suisse

So you added a comment about de-leveraging of the labor expense. Was that for any particular reason?

Ron Sargent

Just across NAD in general with the significant sales decline we are de-leveraging some of our labor expense.

Gary Balter – Credit Suisse

Clarifying the retail, in Q1 you specifically mentioned customer traffic increased. It wasn’t in this quarter’s press release and you mentioned I think on the call it flattened out. Did you see that decline as the quarter went on?

Ron Sargent

I think what we said was slightly negative last quarter and slightly negative this quarter. That is my recollection.

Laurel Lefebvre

The trend has improved from Q4 when traffic had pretty steep declines so we saw much more of a flat trend in Q2.

Gary Balter – Credit Suisse

Could you talk about Easy Tech? You mentioned the triple digit growth. How many people now are working in Easy Tech per store? Are there any dedicated people? Is it still employees that are trained in Easy Tech, what is the outreach program? Obviously you have some very good marketing activity. Are there other programs or is there a calling effort going on now with different companies, etc.?

Demos Parneros

The acceptability is getting stronger and stronger, as I said. In terms of the number of people per store we have a number of multiple people per store that are capable of performing the services in the store. If we have overflow work we also have some of our mobile techs and have them do work as well so we really have a lot of work so the lead time for customers is never longer than we commented, generally fairly quick to begin with.

As far as training and holding onto the people I think that trafficking them has actually been less difficult than a year ago. I think associates have learned about the certification that we established here and the care and the training we put forth to get them ready before they really begin to touch customers’ PCs. So, it has been good in terms of having ready people per store and on the side of the store we could have as many as five trained people in every store. There are no stores without anyone there. We are pretty confident in continuing [growth] of this business.

Gary Balter – Credit Suisse

Are you going out, is this an effort now to go into corporations and try to offer services or is it still being done through the stores?

Demos Parneros

It is primarily still being done through the stores. The promotions we have run over the past year have been very good. It is generating a lot of trial; a lot of trust has been built. I would say exclusively done through the stores at this point.

Gary Balter – Credit Suisse

Theoretically is there any reason down the road especially if you start offering other products it can’t be an outbound service?

Mike Miles

It is an outbound; we do offer outbound Easy Tech services and although most of what we talked about today and as Demos said we are focused on the retail services right now. We have been working on a contract offering for the mid market for tech services. We made an acquisition a couple of years ago of a small company called Thrive that does that service and provides more of a 24/7 tech support for our mid market customers. I think we are right now focused on growing the Easy Tech business but we are getting some experience in the mid market space as well.

Gary Balter – Credit Suisse

We have talked a lot about what has gone right and you have done a great job and deserve a lot of credit for the integration and the margins and everything. Other than international where you mentioned the margins maybe are lower, if you look domestically is there something you could point to that has not gone as well as you would have liked in the Corporate Express integration? How are you fixing that?

Ron Sargent

That is a great question. In terms of things that haven’t gone as well as we would like on the Corporate Express integration, certainly in North America I can’t think of a single thing. Joe?

Joe Doody

Not anything major. I think we have to give the team some pretty high marks in terms of what they have taken on with no due diligence and continuing to focus on satisfying our customers first and foremost while we have gone through this integration process I think we would like it to be faster and get it over with sooner but to do it right it is going to take many years. We have the plans; we just have to continue to execute them. So good question but so far I think I would give the team a 9 out of 10 grade.

Ron Sargent

Operationally it has really worked very well. If I were looking kind of big picture the only thing that has been a little disappointing is how much we had to pay for the debt over the last six months. I think we are doing a great job in reducing that as quickly as possible. Retrospectively if we had waited a little longer we might have been able to finance that five year note for a little less money.

Gary Balter – Credit Suisse

John, given where the Red Sox are what do you going to do in October this year?

John Mahoney

Demos is very happy to hear that question because he sat behind me at the Yankees game on Friday night and still [inaudible] me all night. I think we have to get more hitting. That is all there is to it. 12 runs a game doesn’t appear to be enough for our pitching staff.

Operator

The next question comes from the line of Dan Binder – Jefferies.

Dan Binder – Jefferies

First, throughout the call you have talked about better buying helping particularly the North American business. I was just curious if you had to put a rough range on what that means for gross margin in the last 12 months if you would be willing to put some sort of number to it. Secondly, we have seen some press recently on a combination or at least an alignment of independent dealer through [Tri Mega Group] with SD Richards to go after larger national accounts business. I am curious what your thoughts are on that and why you think it will or will not be successful and how you defend it and so forth?

John Mahoney

Can you just clarify your first question? I’m not exactly sure what you are trying to drive at.

Dan Binder – Jefferies

In terms buying synergies over the last year how much better are you buying?

John Mahoney

I think we have said about 1/3 of the synergies overall are going to be attributable to buying so I guess rough and tough if you thought about 40% of $300 million times 1/3 that would be about the impact we would experience during 2009. I think as we also said, we buy better anyway. There is a lot of things that we have done with partner vendors to try and improve promotion or just better pricing. We think that has allowed us to improve our margin and will over time. The straight, direct synergy only benefit is about what we said, 1/3 of the total synergies.

Ron Sargent

In terms of the independent dealers, first of all we compete with them. Obviously every day they are a strong player out there especially in the local markets. On a nationwide basis having to go to market as we do with our major customers to partner with them to drive delivered cost to the customer you want to be able to partner with them to do that across their organization driving elimination of small orders, increasing average order size, etc.

Hard to do that with the collection of dealers throughout the U.S. I think our model in going to market really would be very difficult I think to compete against us with major fortune 500 customers. They would also want to have a single contact point to be able to drive systems via the program and ensure that it is being fully leveraged and utilized throughout their organization on a nationwide basis which we would be able to address much more consistently than a collection of dealers.

Dan Binder – Jefferies

Is the attrition you expected might occur with the acquisition of Corporate Express, the attrition of some accounts which I think is probably fairly normal in that type of a situation is that more or less as expected or better?

John Mahoney

I think when we looked at the business we didn’t have a lot of information so we obviously modeled that conservatively. We have retained accounts at a higher rate than we had modeled in our original plan.

Ron Sargent

We have done a very good job of integrating the sales organization together and executing pretty high consistency of the same sales contact before, the existing or previous Corporate Express customers. It was noted in our similar comments that about ½ of our field management team came from CE as well as Staples. We have consistency in contact with the customer out there and feel real good about how we have been able to hold onto those customers.

Operator

The next question comes from the line of Michael Baker – Deutsche Bank.

Michael Baker – Deutsche Bank

Free cash flow you said over $1 billion. Am I reading too much into it or I think last quarter you said $1 billion or about $1 billion something like that. Now it is actually over $1 billion. So more enthusiastic on the cash flow line?

John Mahoney

Obviously what we have seen for the first half of the year has been very encouraging in terms of being able to exceed our plan. I would just express caution not to think too aggressively based upon our historical seasonal patterns because to the extent that we start to see the market improve we may want to invest in new inventory to be increase our sales. So that would have some impact on the free cash flow and working capital could grow in the second half of the year. We are optimistic. We expect to achieve more than $1 billion and we are optimistic we are going to do better than we thought at the beginning of the year. I just want to make sure that expectations are in line with our plans.

Michael Baker – Deutsche Bank

Have you been able to quantify the positive impact of your comps from your competitor’s store closures like X number of stores overlapping the stores that have closed and you typically see a bump of X or something along those lines?

Demos Parneros

We have a fairly good idea on a store by store basis with the Office Depot closures. We had reasonably good pickups in the very, very close stores. Honestly I didn’t see any pick up at all. I don’t know what our sales line did. The Circuit closures were a little tougher to read because I think while those stores closed we put a lot of effort on our computing initiatives so I’m sure we had a little bit of a gain from those closures but I would attribute probably as much or more to our internal efforts that we have made.

Ron Sargent

Just to give you a little more color, the Office Depot closures I think were 112 stores affected about 173 Staples stores close by. Circuit City closures have impacted about 408 Staples stores although a little different business and had a little less impact per store.

Operator

At this time there are no further questions. I would now like to turn the call back over to Mr. Sargent, CEO, for closing remarks.

Ron Sargent

My only closing remark is thanks for joining us on the call this morning. We look forward to speaking to you all again very soon. Thank you everybody.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect.

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Source: Staples, Inc. Q2 2009 (Qtr End 08/01/09) Earnings Call Transcript
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