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Office Depot (NYSE:ODP)

Q2 2013 Earnings Call

July 30, 2013 9:00 am ET

Executives

Richard Leland

Neil R. Austrian - Chairman and Chief Executive Officer

Juan Guerrero - Senior Vice President of North American Retail

Stephen M. Schmidt - President of International Operations

Michael D. Newman - Chief Financial Officer and Executive Vice President

Steve Calkins - Senior Vice President of North American Business Solutions

Mike Kirschner - Senior Vice President of E-Commerce

Robert J. Moore - Chief Marketing & Merchandising Officer and Executive Vice President

Analysts

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Colin McGranahan - Sanford C. Bernstein & Co., LLC., Research Division

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

Michael Lasser - UBS Investment Bank, Research Division

Michael Baker - Deutsche Bank AG, Research Division

Daniel T. Binder - Jefferies LLC, Research Division

Mark A. Becks - JP Morgan Chase & Co, Research Division

Joseph I. Feldman - Telsey Advisory Group LLC

Anthony C. Chukumba - BB&T Capital Markets, Research Division

Operator

Good morning, and welcome to the Second Quarter 2013 Earnings Conference Call. [Operator Instructions] At the request of Office Depot, today's conference is being recorded. I would like to introduce Mr. Richard Leland, Vice President, Investor Relations and Treasurer, who will make a few comments. Mr. Leland, you may now begin.

Richard Leland

Thank you, and good morning. Joining me today are Neil Austrian, Chairman and Chief Executive Officer; Mike Newman, Chief Financial Officer; and Steve Schmidt, President of International. We also have our North American business leaders, Juan Guerrero, Senior Vice President for Retail; Steve Calkins, Senior Vice President for Contract; and Mike Kirschner, Senior Vice President for Direct.

Before we begin, I'd like to remind you that our discussion this morning includes forward-looking statements, which are subject to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements reflect the company's current expectations concerning future events and are subject to a number of factors and uncertainties that can cause actual results to differ materially. A detailed discussion of these factors and uncertainties is contained in the company's filings with the SEC. The SEC filings, as well as a reconciliation of the non-GAAP financial measures discussed on the call to the most directly comparable GAAP financial measures, along with the webcast slides for today's call, are all available on our website at investor.officedepot.com.

Before we discuss the results, I want to remind you of the financial reporting changes we made last quarter, namely modifying divisional operating income by allocating additional general, administrative and other expenses, as well as the reclassification of shipping and handling expense out of operating and selling expenses and into cost of goods sold. Full descriptions of these reporting changes, along with recast historical financial results were included in the press release and in the 8-K filed with our first quarter results on April 30, 2013.

I'll now turn the call over to Neil Austrian.

Neil R. Austrian

Thank you, Rich, and good morning, everyone. Before I review the second quarter financial results, I wanted to mention 2 important milestones in the company's history that occurred earlier this month. First, on July 9, we closed on the sale of our 50% Mexican joint venture to Grupo Gigante. They've been wonderful partners dating back to when Office Depot de Mexico was first founded in 1994, and I'm confident they will continue to be excellent stewards of the brand going forward in Latin America. I'm also very pleased with the valuation that we received on the Mexican JV sale. The management and the board initiated a thoughtful strategy starting in late 2011 to begin illuminating the value of this business to our shareholders. It started by providing additional disclosure on the performance of the JV during our quarterly conference calls. It developed into what could have been an interesting but somewhat longer-term potential public offering for the business and it culminated in Grupo Gigante purchasing the business for approximately $680 million. The roughly $550 million of after-tax proceeds will significantly enhance our liquidity and financial flexibility as we continue to progress toward the proposed merger with OfficeMax.

The second important milestone occurred on July 10, when the shareholders from both Office Depot and OfficeMax gave their overwhelming support to approve the proposed merger. At concurrent special meetings, over 98% of the shares voted from each company were voted for the merger. This is a strong endorsement of the strategic rationale behind this merger to create a stronger and more efficient world-class provider of office products, services and solutions with significantly improved financial strength and the ability to better compete in today's rapidly changing industry and deliver long-term shareholder value. As you remember, we began to explore the possibility of this transaction well over a year ago and I'm very pleased to have passed this milestone. The final step in the merger process will be FTC approval and we remain optimistic that the transaction will close by the end of this year.

Lastly, we filed a joint press release yesterday with OfficeMax, which provided an update on the merger integration process, including some additional synergy details. Mike Newman, who is leading the integration effort for Office Depot, will provide his perspective on the process later in the call.

Turning to the financial results. Office Depot reported second quarter 2013 sales of $2.4 billion, down 4% compared to the prior year in both dollars and in constant currency. The shift in the timing of the Easter holiday had a small positive impact on sales compared to the prior year, but it was offset by country exits in the International division that occurred in late 2012 and in the first quarter of 2013. The company reported a net loss after preferred stock dividends of $64 million or $0.23 a share in the second quarter compared to the same net loss after preferred stock dividends of $64 million or $0.23 a share in the second quarter of 2012. Second quarter 2013 results included approximately $30 million of pretax charges comprised primarily of merger and certain shareholder-related expenses, restructuring activities and approximately $4 million of noncash store impairment charges in the North American Retail Division. Excluding these charges, the net loss after preferred stock dividends was $28 million or $0.10 a share. The prior year results included approximately $33 million of pretax charges, which included $24 million in store asset impairment charges and $9 million in restructuring costs. Additionally, there was a $16 million income tax credit in the quarter. Excluding these items, the second quarter 2012 net loss after preferred stock dividends was $40 million or $0.14 a share.

EBIT, adjusted for charges, was a loss of $8 million in the second quarter of 2013 compared to an EBIT loss of $22 million in the prior year period. The $14 million year-over-year improvement in adjusted EBIT was attributable to a significant cost control resulting from our strategic initiatives in maintaining margins in a difficult sales environment. We remain focused on executing against these multiyear initiatives, which are continuing to demonstrate tangible results while we also make smart, long-term investments to significantly increase the level of engagement with our customers.

Next, Juan will review the second quarter performance for our North American Retail Division.

Juan Guerrero

Thank you, Neil, and good morning. The North America Retail Division reported second quarter 2013 sales of $939 million, a decrease of 5% compared to the prior year. Same-store sales in the 1,077 stores that have been open for more than 1 year decreased 4%. We continue to experience weakness in our technology and peripherals category during the quarter, particularly in mid-priced laptops where we have historically held a large portion of our laptop assortment. Additionally, the market transition out of laptops into tablets continued in the second quarter. We are refocusing our product mix throughout technology to stay ahead of the changing trends in this category. This is part of an ongoing transition within the stores to refresh and expand our product lines in order to provide customers with a more unique and relevant selection of products and solutions.

As part of this process, we are partnering closely with our key vendors to make sure we have the newest selection of products available. We are also adding several new vendors, especially in the technology and peripherals area with products focused on the increasing trends of a more mobile office and staying connected. Our goal is to streamline and accelerate our new product introduction process, so that each year we are rolling out hundreds of innovative new products to our customers.

In other product categories, furniture sales were down as we were less promotional compared to the prior year. Supply sales decreased marginally from the prior year period. However, we were pleased with continued sales growth in the second quarter in Copy and Print Depot and in breakroom supplies, which are 2 key service and solution areas that are performing well and are continuing to resonate with our customers.

North America Retail's average order value was down approximately 3% in the second quarter and customer transaction counts declined about 1% compared to the same period last year. The North America Retail store count at the end of the second quarter of 2013 was 1,109 stores. During the quarter, we closed 5 stores, opened 3 new stores and relocated 1.

The adjusted operating loss in the North America Retail was $20 million in the second quarter of 2013, excluding approximately $8 million of charges related to noncash store asset impairments and severance. These results compare to an adjusted operating loss of $26 million in the same period last year. The improvement from the prior year reflects initiative-driven cost reductions, including advertising, payroll and general and administrative expenses, partially offset by the negative flow-through impact of lower sales. There was also a significant improvement -- excuse me, a slight improvement in gross margin compared to last year.

Our Back-to-School season kicks off in the third quarter. And this year, we are very excited about our product assortment, our new programs and partnerships and a powerful new media campaign. We are investing in programs with a high expected return that will significantly engage and excite our customers. First, our new Office Depot Rewards loyalty program, which launched on July 1, is unique in the industry and offers our customers flexibility and choice. We offer 3 membership types with personalized offers designed for each: Local Businesses, Loyal Customers and Star Teachers. The program also offers many ways to earn reward points through shopping, connecting and recycling.

In June, we announced an exciting partnership with the hottest musical group on the planet, One Direction. Through our "live nice" anti-bullying campaign that includes exclusive One Direction merchandise, in-store interactive displays and augmented reality technology within our mobile app that brings products to life, we are creating excitement about the Office Depot brand that will drive purchases of the entire Back-to-School basket. After announcing the One Direction partnership, our social media traffic on Twitter increased significantly and we experienced exponential growth in the number of followers of our Office Depot Facebook page. Additionally, our Back-to-School season will include new and exciting products that students want, including a number of Office Depot exclusives. Our media campaign is designed to build on this using a where did you get that theme. We believe all of our marketing vehicles will succeed in their goal of engaging students, parents and teachers throughout the Back-to-School season.

Looking forward to the third quarter of 2013 for the North America Retail Division, we anticipate our same-store sales rate to decline low-single digits. Third quarter adjusted operating income is expected to be flat to slightly up compared to the prior year as we continue to manage expenses to offset the impact of the expected sales decline.

Next, Neil will review our North America Business Solution Division second quarter results.

Neil R. Austrian

Thank you, Juan. I'll cover the BSD results, and Steve Calkins and Mike Kirschner will join us in the Q&A portion of the call to answer any questions.

The North American Business Solutions Division reported second quarter 2013 sales of $781 million, a 2% decrease compared to the same period last year. In the Contract channel, second quarter 2013 sales declined low-single digits from last year. Sales grew within the small- and medium-sized business customer group, although we did experience sales softness with our enterprise customers. We anticipate continued pressure with respect to this group as some larger customers may be taking a wait-and-see approach with respect to the merger.

During the second quarter, we enjoyed positive sales on our public sector business, excluding the federal business, which was negatively impacted by continued budgetary pressures. In particular, we experienced positive sales with our K-12 customers and with state and local businesses. Also, in the second quarter, we made the decision to restructure our technology sales organization, which included the consolidation of resources into our inside sales organization in Austin, Texas. While this decision negatively impacted revenue during the quarter, there was no impact to operating income as sales declines were offset by improved operating efficiencies and margin rate improvement.

Outside of the federal and technology impacts, Contract sales were slightly positive for the second quarter. With respect to product categories within Contract, we had positive sales growth across many of our solution categories. There were sales increases in Copy and Print Depot, cleaning and breakroom supplies. Inversely, we experienced sales declines in paper and in ink and toner.

In the Direct channel, second quarter 2013 sales were down slightly versus last year. Growth in online sales was offset by continued pressure of lower purchases from customers who shop using catalogs and order through our inbound call centers. Sales were also soft in the supplies category. However, Direct had year-over-year sales increases in technology and ink and toner.

We continue to improve our e-commerce platform and the omni-channel experience for our customers, seeing meaningful improvement in customer satisfaction and increased mobile sales. As we focus on improving how our customers interact with us, we continue to enhance our search content and checkout functionality. Multichannel and mobile shoppers can more easily navigate and organize for their Back-to-School needs, engage with our new Office Depot Rewards program and use social logins. Continuing to make the shopping experience easier for our customers has positively impacted our online growth.

In total, North American BSD reported second quarter 2013 adjusted operating income of $31 million versus $20 million in the prior year. The $11 million improvement reflects a slight gross margin increase driven by product margins and cost management and supply chain, as well as lower advertising expense and cost management within payroll and other expenses. The outlook for BSD in the third quarter of 2013 includes sales slightly down versus last year and adjusted operating income to be up versus the prior year.

I'll now turn the call over to Steve Schmidt, who will talk about the International division.

Stephen M. Schmidt

Thanks, Neil. The International Division reported second quarter 2013 sales of approximately $698 million, a decrease of 3% compared to the prior year period in dollars and in constant currency. As Neil mentioned earlier, we experienced a small positive sales impact on the Easter holiday timing compared to the prior year, but it was offset by country exits in late 2012 and in the first quarter of 2013 as we continue to strategically evaluate our international portfolio.

As I speak to year-over-year International Division sales comparisons by channel this morning, please note that I'll do so in constant currency.

The European economy continues to struggle as the recession persists in the second quarter of 2013. We continue to take a number of initiative-based actions to counter the difficult economic environment in Europe. Our fixed direct initiative, for example, is getting additional traction driven by the Web. We have seen 5 consecutive quarters of improving sales trends in the European Direct channel, and we'll continue to focus on this business. We are making significant improvements to our websites, including landing page and checkout enhancements, as well as search engine efficiencies. We are also being more targeted with our catalog and direct mail distribution as customers move to the Web.

Margin was down in the second quarter, largely because we decided to be more strategic in key categories, including taking competitive pricing actions on ink and toner, particularly in the U.K. region. These actions drove sales in the quarter and have had a positive impact on our customer base. Total European Contract sales decreased mid-single digits in the second quarter of 2013 versus the prior year as growth primarily in Switzerland and Austria was more than offset by sales weakness in other countries. In Asia, Contract sales were flat to the prior year.

Sales trends improved in the European Retail channel in the second quarter of 2013 with growth in France and an improved negative trend in Sweden. In Asia, retail sales in South Korea increased mid-single digits compared with 1 year ago. During the second quarter, we began the process of closing operations in our small joint venture in India as we continue to evaluate our international portfolio.

The International Division reported an adjusted operating loss of $5 million in the second quarter of 2013, excluding approximately $6 million of charges from our initiative-driven restructuring actions and the exit from our joint venture in India. These results compare to an adjusted operating loss of $2 million in the same period last year. The year-over-year decrease was primarily due to lower sales volume and the gross margin pressure I mentioned, particularly offset by operating expense reductions related to our continuous process improvement initiatives.

The movement in exchange rates had a minimal impact on the International Division operating income in the second quarter of 2013 compared to the same period in 2012. Neil previously noted that on July 9, 2013, the company closed on the sale of its 50% investment in Office Depot de Mexico to Grupo Gigante. The sales provided significant value for our shareholders and enhances our liquidity position going into the planned merger. With the exception of 10 days of activity in July, we will no longer report the company's portion of the joint venture's net income in the miscellaneous income net line on the statement of operations. The company's portion of the joint venture net income was $7 million in first quarter of 2013 and an additional $7 million in the second quarter of 2013. The gain on the sale of the JV will be recognized in the third quarter of 2013 as a component of other income in the statement of operations.

As far as operating results in the second quarter 2013, Office Depot de Mexico reported sales of $275 million and a net income of $14 million. In regard to the third quarter 2013 outlook for the International Division, we expect sales in constant currency to decline mid-single digits versus the prior year due primarily to the weak European economic conditions. The division also expects third quarter 2013 adjusted operating income to be flat compared to last year as the negative sales trends more than offset the cost reduction efforts.

I'll now turn the call over to Mike Newman for the financial results and an update on the merger integration process. Mike?

Michael D. Newman

Thanks, Steve. Second quarter 2013 total company EBIT, excluding merger and certain shareholder-related expenses, restructuring activities and store asset impairment charges was negative $8 million or $14 million better than the prior year's negative $22 million. The $30 million in pretax charges reported in second quarter 2013 included $17 million in merger and certain shareholder-related expenses, $4 million in North American Retail asset impairments and approximately $9 million in charges related to European and North American business restructuring activities.

With the $14 million EBIT improvement in the second quarter, year-to-date adjusted EBIT through June 2013 was $10 million lower than the same period the prior year. The waterfall chart on Slide 10 highlights the drivers of the $14 million year-over-year improvement in adjusted EBIT for the second quarter.

The company realized approximately $39 million in benefits from business initiatives in the quarter, which more than offset a $24 million decline from lower sales volume and other discrete items. Benefits accelerated from the first quarter as planned, and we still expect to realize $120 million to $140 million in initiative benefits this year. We continue to execute on our margin and operating expense initiatives, while investing in new products and programs in each of our divisions to drive profitable sales.

Turning to Slide 11. Free cash flow was a use of $34 million for the second quarter of 2013 versus a use of $66 million in the same period last year. Capital spending was $34 million in the quarter.

Based on our current outlook, excluding the impact of the Mexico JV sale, the company expects free cash flow to be approximately 0 in 2013 as our estimate last quarter of merger and shareholder-related expenses has increased from $70 million to approximately $85 million for the year. The other components of our cash flow outlook remain largely the same.

Office Depot ended the quarter was $472 million of cash and cash equivalents and $742 million available from the asset-based lending facility, or ABL, with total liquidity of $1.2 billion. No amounts were drawn under the ABL at the end of the quarter, and after the close of the quarter, we received approximately $550 million in after-tax cash proceeds related to the Mexico sale.

You may have seen that today, we initiated a par tender offer for our outstanding 9 3/4% bonds due in 2019. This was a requirement under the indenture that was triggered by the sale of Mexico. We do not expect any significant holders to participate as the bonds have recently traded at a significant premium to par.

Total company operating expenses adjusted for merger and certain shareholder-related expenses and store asset impairment charges and restructuring activities were down $38 million. This year-over-year improvement includes $12 million from general and administrative expenses. I'm very pleased with the progress we're making on reducing our G&A costs through initiatives and targeted reductions. Year-to-date through June 2013, G&A expense is down over $19 million from the same period last year.

Moving to taxes. The company recorded a small tax benefit in the quarter. The second quarter 2013 tax rate on a non-GAAP basis was 28%. On a cash tax basis, the company paid about $2 million in the second quarter. And excluding the roughly $130 million in taxes related to the sale of our Mexico JV, we expect full year cash taxes to be $10 million to $15 million. Separately, we expect to receive a $14 million tax refund in the third quarter related to prior periods.

During the second quarter of 2013, the company recorded a dividend on a convertible preferred stock of $10 million, which was paid in cash on July 1, 2013. And on July 11, 2013, we redeemed 50% of the outstanding preferred stock for $216 million as required under the merger agreement. The quarterly dividend on the remaining preferred stock will drop to about $5 million going forward.

In regard to the third quarter 2013 outlook, we expect total company sales to be down approximately 3% to 4% versus the third quarter of 2012. This is based on low-single-digit sales decreases in North American Retail and a slight decline in BSD and mid-single-digit declines in International. We expect third quarter 2013 adjusted EBIT to be up from the prior year. And for the full year 2013, Office Depot anticipates adjusted EBIT of approximately $130 million. This is consistent with our prior guidance as we've adjusted our $150 million target down by $19 million to reflect the lost miscellaneous income in the second half of the year resulting from the sale of Mexico.

As Neil mentioned earlier, I'll now provide you with some additional thoughts on yesterday's joint press release related to the status of the integration planning process.

With the help of the Boston Consulting Group as our external partner, both Office Depot and OfficeMax have been very active in planning for the merger integration. In total, we've established 12 different integration planning teams that are tasked with developing the detailed integration strategies and day 1 operating plans for the combined company. A key organizational design principle is that each team has representation from both companies to ensure complete visibility into the nuances of how each business operates and to capture any interdependencies. If necessary, a clean room process is available so planning can continue, while still protecting any competitively sensitive information before the merger is approved. From a project management perspective, we have established an Integration Management Office to guide the day-to-day integration design and planning, identify interdependencies and risks and develop any mitigation plans, if necessary.

I'm happy to be working with Steve Parsons, who is now leading the integration planning process from the OfficeMax side.

We have also established a steering committee to provide project governance and direct the overall integration strategy. This committee is made up of senior executives from each company and meets face-to-face on a regular basis. Between the 2 companies, we have over 150 people actively engaged in the merger integration. They, in turn, are supported by a dedicated team from Boston Consulting. The level of engagement and collaboration is very high at all levels, with frequent communication and on-site meetings in either Boca Raton or Naperville. As someone who has direct oversight for this process, I can say with great confidence that this planning is going very well.

Leading up to the merger, both companies did an independent analysis to estimate potential synergies. The management teams then spent 2 days together in New York in order to learn more about each other's respective business and share their synergy estimates. The results were amazingly similar and gave us a high degree of confidence in the $400 million to $600 million range that we laid out for potential synergies when the merger was first announced. Over the past several months, we've continued to refine these estimates, both internally, as well as externally with Boston Consulting, and I'd like to give you an update and some insight into the various synergy categories.

In total, the combined company will have a cost base of nearly $18 billion. Because we see most of the synergies in North America, we have removed approximately $5 billion in international costs, as well as another $2 billion of costs that will be assessed post-closing. This leaves a combined North American cost base that we are currently addressing of approximately $11 billion. The largest potential synergy category was identified as in purchase efficiencies related to over $8 billion in combined cost of goods sold.

Total purchasing synergies could reasonably run between $130 million and $200 million, or roughly 1.5% to 2.5% of cost of goods sold. The second potential synergy category is related to the approximately $1 billion in North American supply chain and shield operation cost. As you know, we have had good success over the past several years in taking costs out of our supply chain on a stand-alone basis. We believe that network optimization, transportation and delivery efficiencies, along with optimizing field operations, could generate roughly $70 million to $100 million in potential synergy savings.

The third potential synergy category is related to the approximately $500 million in combined North American advertising and marketing expense. We believe we can realize a substantial amount of savings in this area by reducing duplicate spend on weekly inserts, media, catalogs, as well as other advertising and marketing vehicles. In total, we believe that synergies in this area could range from $70 million to $100 million.

And lastly, the merged company will have a combined selling, general and administrative spend of approximately $1.5 billion annually. And based on the work that has been done by the team so far, as well as comparable benchmarks we have reviewed with Boston Consulting, we estimate that synergies in this area could be potentially $130 million to $200 million annually.

Overall, the progress we have made in integration planning, the talent and dedication of the teams, along with the additional analysis we have performed on the combined company's cost structure over the past 5 months, gives me a high degree of confidence that the total annual synergies will be within our $400 million to $600 million guidance. In addition, we are putting the detailed plans in place in order to realize approximately 1/3 of the potential synergies in year 1. We continue to expect approximately $350 million to $450 million in onetime costs and approximately $200 million in capital investment to achieve these synergies. As you know, we have been successful at Office Depot in delivering cost savings of between $120 million to $180 million per year for the last several years. The OfficeMax team has been working hard at delivering cost savings in their business and doing the same. We realize that the synergy benefits are an important part of the shareholder value that is being created from this merger and believe that we have the talent and discipline to deliver.

I'll now turn the call back over to Neil.

Neil R. Austrian

Thanks, Mike. As you can see, this has been an important year for the company. We're very excited about our major initiatives taking place right now, all of which are a direct result of the multiyear strategic plan we've been speaking to you about for some time and the momentum we've built executing on our plan to improve the company's core operating results.

We recognize there's still work to be done and that several critical milestones are yet to come, most specifically as it relates to the successful completion of and execution upon our planned merger with OfficeMax. But as you've heard today, this management team and our board are intensely engaged on all levels to make sure we achieve the best possible results, even amid a tough operating environment. The merger of equal structure has required joint decision-making and trust from both companies, and our board and management team have invested a considerable amount of time in establishing the necessary relationships and lines of communication with OfficeMax.

In the upcoming quarter, it's critical that our established team be able to continue on our momentum with respect to integration planning, including the ongoing CEO search, to position us to hit the ground running on day 1. We plan to be out on the road over the coming weeks talking directly to our shareholders, and we look forward to sharing our perspective with you in greater detail. We remain very positive about Office Depot's positioning for the second half of this year with Back-to-School season upon us and new products rolling out. We feel very strongly that we're on the right path and are eagerly pushing ahead to continue to improve results. Maintaining focus and execution are everyone's primary goals right now as we transform this business and continue to improve our operating performance for the benefit of all shareholders.

That concludes our prepared remarks. Operator, we're now ready to take questions.

Question-and-Answer Session

Operator

[Operator Instructions] The first question is from Matthew Fassler.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

It's Goldman Sachs. A couple of questions. First of all, your retail traffic, down only 1% was, I think, the best showing you've had in a couple of years, obviously, compared to recently. But other than that, anything that you did or that's happening in the environment to which you would attribute that moderation?

Neil R. Austrian

Juan?

Juan Guerrero

Yes, Matthew, we have been seeing this trend over the past quarter -- 2 quarters so this is a trend. And we continue to be encouraged by the direction of that trend. Obviously, we're being offset by pressure from laptops, as well as ASP on tablets. But in terms of traffic trend, we are very encouraged.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Can you say whether it seems to be the consumer or the small business customer who is sort of stopping the reduction of business?

Juan Guerrero

We don't have enough data yet to be able to talk any more about traffic. But certainly, overall, we're seeing the trend. I think this is something that as we go into Back-to-School, we'll be able to track a little bit better and talk about as we come out of Q3.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Okay. A second question for Mike. As you were walking through the cost buckets associated with synergies, you said that there was a $2 billion line item that you were going to assess later on. Can you just say generally what that line item relates to?

Michael D. Newman

Yes, it relates to occupancy and store labor. And since we've started this process and this project with OfficeMax, for competitive reasons, we just said that we would assess it post announcement of the FTC approval.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Got it. And then finally. . .

Michael D. Newman

Any synergies we quoted obviously exclude that.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Understood. And then finally, just on the tech side, you talked about the transition to tablets. Despite Apple having perhaps a bit less momentum, it seems like its competitors aren't doing a whole lot better in the tablet arena. So can you just talk about the program that you're able to put in place to compete in that arena without access to the iPad?

Juan Guerrero

Yes. Matthew, it's Juan here. We continue to adjust our assortment. We're actually adding new categories that we've not been in before to try to adjust for the pressure we're seeing in this technology category. We're very encouraged by the rollout of our new products. And as we ramp up that engine, we should see the performance from that particular effort show up in our results.

Operator

The next question is from Colin McGranahan.

Colin McGranahan - Sanford C. Bernstein & Co., LLC., Research Division

It's Sanford Bernstein. Two questions. First, on BSD, the top line was a little light, specifically in Contract, and Neil, I think you mentioned that some of the enterprise customers may be showing some wariness. Can you talk about your win/loss ratio and specific bids and what you're seeing from those customers and whether there's a competitive element to it as well?

Neil R. Austrian

Sure. Let me have Steve Calkins answer that for you, Colin.

Steve Calkins

This is Steve. First of all, we are still winning larger customers in this space. But we are sensing from customer feedback that many of them want to understand more about the merger with respect to the implementation pains they might go through in terms of the switch from one supplier to another. But the competition is increasing, certainly, on the street, both from independents and from our primary competitors. So that is nothing really new in our space.

Colin McGranahan - Sanford C. Bernstein & Co., LLC., Research Division

Okay. And is there any kind of an outreach you have to your customers as you try to -- obviously, you're making progress and milestones in the merger as you kind of bring them along with you, especially for contracts that you know are coming due in the next 6 to 18 months?

Steve Calkins

Yes. Typically, what we're telling customers is that this is intended to be a seamless transition to them. We want to make sure that they -- we methodically transition customers post merger. But we can't make any promises with respect to customers on which platform they'll be on post merger. So to the field, it is business as usual. Competition is the same. But we are telling our customers that the goal is to be as seamless as possible with respect to the transition.

Neil R. Austrian

What I can add on also is we've seen a continued budget crunch from the federal government, which has clearly impacted the sector. The positives are we continue to see gains in the SMB sector where we've been focused for the last 2 years, and we're seeing the payoff come in terms of what we've done come in terms of our inside sales organization in Austin. The positive also is where we've seen some real increases in K-12, which is one of the sectors that we've gone after very hard and it seems to be paying off.

Colin McGranahan - Sanford C. Bernstein & Co., LLC., Research Division

No, no. Clearly, the initiatives you've been executing seem to be going well. I was just concerned that maybe we were starting to see a little bit of a building groundswell from some of the enterprise customers of weariness ahead of the merger. Second question for Mike. Just on the merger synergies, 3 quickies. One, there was nothing in there around the store synergies. How have you looked at that? And what -- how can you comment on that at this point?

Michael D. Newman

Yes, that was really Matt's question on what we excluded. We excluded -- there's $2 billion of costs excluded for occupancy and store labor. That's been out of scope and that we're -- because of competitive reasons, we're not going to deal with until after the merger is announced. So that's the approach we've taken there.

Colin McGranahan - Sanford C. Bernstein & Co., LLC., Research Division

Okay. And then the purchasing number seemed pretty good. The advertising synergy numbers seemed maybe a little conservative. Any thoughts on the amount of work you've done against those 2?

Michael D. Newman

We've done a lot of work on purchasing. We've done some work in a clean-room environment that makes us very comfortable with that. I'm not going to get into commenting on the relative conservatism or not of each bucket. The thing I will mention is that one of the things you'll be hearing from us in the future is we've not talked about working capital synergies. We're working on that now. And you've got a new company that's going to have well over $1 billion in inventory, well over -- almost $2 billion in payables. As we look at the 2 companies, we look at processes, we look at supply chain, we think there's a considerable working capital opportunity here that falls outside of the $400 million to $600 million of benefits that we've talked about. So that's an area certainly to stay tuned on.

Colin McGranahan - Sanford C. Bernstein & Co., LLC., Research Division

Okay. That's helpful. And then it sounds like you're excluding all of the COGS from International. I understand, obviously, some of the SKUs are different and the overlap is there, but wouldn't there also be some volume purchasing benefit from global vendors?

Michael D. Newman

There could be some carryover impacts in COGS. And we also have -- running through particularly all of these different buckets, we have an indirect initiative which is very significant in which both companies have had great success within the last few years. So we think there may be some play in both COGS and indirect, as well as the direct import aspect. OfficeMax does a very good job on direct import. There are some things we're going to learn there. We've not included those impacts to-date because we're trying to keep this focus in North America initially, but your point's a good one. There could be some potential there.

Operator

The next question is from Brad Thomas.

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

Brad Thomas with KeyBanc Capital Markets. The first one I'll just ask on the retail segment. We haven't heard too much this year about your smaller formats or can you talk a little bit more about how those have been performing?

Neil R. Austrian

Yes, this is Neil. Basically, once the merger was signed, we basically decided to significantly change our CapEx in terms of remodels, relocations until we really understood what the combined company footprint might look like after the merger. So at this point in time, that's been really slowed down, and we're going to take a wait-and-see attitude until 2014.

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

Okay, fair enough. And then with respect to thinking about the company and how much of these synergies you could flow through to the bottom line -- recognize that it's probably a question for the new CEO of the company once that's named. But Neil, as you and Mike look at this, can you give us a sense of how much you think you could actually flow through to the bottom line versus what level of reinvestment you may need to put into the P&L?

Neil R. Austrian

This is Neil. I really think that is the new CEO's decision in terms of how they plan, or he or she plans, to transform the business. But I think that, initially, there's not going to be a significant amount of reinvestment required. I think a large part of the synergies can flow to the bottom line. And I think if there's any help whatsoever in a very small increment from the economy, you should see most of this fall to the bottom line.

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

Good. And then one more housekeeping item for Mike. You referenced working capital. One other item that I don't think has been discussed is tax rate. I believe Office Depot has a sizable amount of NOLs. Do you have a sense of what the P&L and the cash tax rate may look like for the combined company?

Michael D. Newman

No, not yet. But we've already started working with Max to look at tax planning going forward. And we'll be -- that's down the road a piece.

Operator

The next question is from Michael Lasser.

Michael Lasser - UBS Investment Bank, Research Division

It's UBS. Can you update us on any dialogue that you've had with the FTC in the last 3 months or since they've put in their second request and the nature of that dialogue?

Neil R. Austrian

What I would say is that it's going as planned, and we fully expect to have an answer prior to year end.

Michael Lasser - UBS Investment Bank, Research Division

Okay. My second question is on some of the disruption or pushback that you're getting from your enterprise customers on the merger. What have you factored in to your second quarter -- sorry, your third quarter outlook as far as how that's going to unfold between -- over the next few months? Do you expect that, that's going to get worse, get better or about -- stay about the same?

Steve Calkins

Yes, I don't think we're going to parse our prior statements. I think what we indicated in the call earlier was that we expect a slight decline overall in BSD.

Neil R. Austrian

Yes.

Michael Lasser - UBS Investment Bank, Research Division

Okay. I guess, have you seen those customers go elsewhere such that you're starting to see the leakage have a meaningful impact on the business and it could get worse?

Steve Calkins

Yes. So we are seeing some feedback from some prospects that the merger is a consideration and a decision. We are still winning accounts every day. With respect to our current customers, we are growing share of wallet through solution categories and other products offerings. Generally, the space has been a little soft in the second quarter, but I don't think we want to parse our statement any further than what we've already indicated.

Operator

The next question is from Michael Baker.

Michael Baker - Deutsche Bank AG, Research Division

So my question on the top line is, is there anything you see that helps you stem the tide of the sales declines as a combined company? In other words, any kind of sales synergies you can point to? Or is it really just waiting for the economy to get better? And then a second question, just a clarification on the EBIT guidance being up in the third quarter. Does that exclude -- it obviously excludes Mexico in the third quarter of 2013. Is the proper comparison EBIT versus 3Q '12 excluding Mexico?

Neil R. Austrian

Let me first state the -- that the sales at the top line, we're not waiting for the economy. We've never waited for the economy in the last 3.5 years. Basically, what Juan had talked about or what we've done is we've reorganized the merchandising department. We have a whole plan for new products that just started in Q2, which will go through the rest of this year and into next year. I think that as I've long said and has Ravi, is that this merger basically will give the new combined company a balance sheet and the means to transform itself, and I think that clearly will happen. So I don't see, at this point, that we're just waiting for anything. I think the marketing plan we've got for the third quarter where we had One Direction, I think, at the end of the -- at the quarter, we're going to see a significant degree of excitement in terms of coming into the Office Depot stores. We've already seen that in the first quarter. Each of the concerts that these kids are performing at, there's a very long Office Depot commercial that ties it in. As it relates to the EBIT thing, Mike, why don't you. . .

Michael D. Newman

Yes, yes, you're right. It's -- our guidance is that EBIT will be up in Q3, excluding the impact of Mexico. And the 3Q number for Mexico last year was about $10 million or $11 million.

Michael Baker - Deutsche Bank AG, Research Division

Okay. One more follow-up, a couple of people have asked questions around this. But just on the enterprise customers, there's been some sluggishness, et cetera. Have you actually lost any enterprise customers since you've lost -- since you've announced the merger? Or has there been losses above and beyond what you would normally expect in the normal course of business?

Steve Calkins

I would say that our losses are pretty steady with what we've been seeing over the last several years. There hasn't been any significant losses post merger.

Operator

The next question is from Daniel Binder.

Daniel T. Binder - Jefferies LLC, Research Division

Dan Binder with Jefferies. Could you just isolate what the Easter benefit was in the quarter, how that impacted the different divisions? And then, if you could also address the leakage, it seems, you're getting in Direct as perhaps not all of the catalog customers are transitioning to online, how you think you can deal with that?

Steve Calkins

Yes, for retail, it was a very modest impact, around 20 basis points. So not material to the overall performance.

Juan Guerrero

No, I agree. The same thing within Contract.

Neil R. Austrian

And International, Steve, it was minimal but it was offset by exiting several countries. The next question was, what, are our catalog sales?

Daniel T. Binder - Jefferies LLC, Research Division

Well, you talked about how catalog is soft but online is growing. But net, you've got Direct channel, I think, was down. So I'm just curious as it would appear that your catalog customers may be dropping off in the way that they shop for that business and maybe it's not all going to your online. I'm not sure if it's -- where else it's going, but any thoughts on how you deal with that?

Mike Kirschner

Yes. This is Mike Kirschner. What we're seeing is catalog customers shifting out of the call center channel into other channels, and what we're trying to do is take an omni-channel approach and make sure we land those customers somewhere within Office Depot, whether it be a store or online, and that's what we're going after.

Daniel T. Binder - Jefferies LLC, Research Division

Okay, great. Any thoughts on early Back-to-School in terms of competitive pricing and what you're seeing out there versus the promotional posture last year?

Neil R. Austrian

Juan?

Juan Guerrero

There's really no difference year-over-year. We're seeing, I would say, very similar environment to last year, very competitive, but no different than what we saw last year.

Operator

The next question is from Christopher Horvers.

Mark A. Becks - JP Morgan Chase & Co, Research Division

This is actually Mark Becks on for Chris from JPMorgan. First question, just on gross margin, you previously just suggested some margin drivers in the back half. Wondering if you're still feeling good about gross margins? I know you mentioned on the International side, you had a step-up efforts with ink and toner, specifically. And then as a follow-up to that, maybe give us an idea of where you're at on pricing versus Amazon and some other online players. And is there a risk that you would have to be more promotional on the retailer Contract side?

Stephen M. Schmidt

Chris, this is Steve. Regarding the International comment, that was really driven by a strategic decision we made in the U.K. region, as well as docks, to basically be more competitive. We benchmarked our pricing across key categories, ink, toner, paper, which are obviously very large categories for us and made the strategic decision that we needed to be price competitive. We are priced higher than the market. We took those pricing down and we found very favorable impacts thus far. We've been able to reverse negative sales trends, and we're confident that at this point, the decision is right. So from a bottom line standpoint, the net impact has not affected our overall operating results.

Mark A. Becks - JP Morgan Chase & Co, Research Division

And then on the Retail side, in Contract here in North America, do you feel, from a promotion standpoint, you guys are sort of right-priced versus your competitors? Or is there a potential that you could see some of the similar promotions take shape here?

Juan Guerrero

Yes, for Retail, we feel that we're tracking very closely on the market. We've had a pricing initiative that we continue to push. And we are monitoring. Certainly, we've noted that we pulled off promotions in furniture. But as we move forward, we don't see anything material that would change our strategy.

Steve Calkins

Yes, on the Contract side, we obviously -- we treat promotions a little bit different than are typical in Retail, so I'll just make a general comment about gross margin improvement that we've seen coming from improved SMB. So a lot of it is in the customer mix, improved share of wallet and improved growth in our solution categories across different segments, including in the public sector and in our larger customers as well. We do incentivize at all levels, but, obviously, we try to incentivize to improve our margins and balance the top line with the goal, obviously, to improve operating profit overall.

Mark A. Becks - JP Morgan Chase & Co, Research Division

Okay. And then just last question for me on -- Contract has come up a lot, obviously, the uneasiness heading into the merger. Maybe proactively, what you can do with your customers to make sure that they're comfortable with the transition process? And then also, historically, is there anything that you've seen from past mergers in the space as far as a churn rate and perhaps any sort of idea what you may think about that going forward?

Steve Calkins

Yes. First of all, with respect to our current customers, I think this came up on the call last quarter as well, our goal is to communicate to them and to execute against this promise that any transition is going to be seamless to them. We've gotten some questions from customers and we addressed those questions. And so far, with respect to current customers, we think there's a general comfort level that the merger is going to be positive overall with respect to them. And with respect to growing the enterprise space, again, we've experienced some feedback from prospects that there's some latency approach out there with respect to implementation. But to make it clear, we are winning accounts in that space and we are winning more accounts than we're losing.

Neil R. Austrian

The other I'd add is that at the Steering Committee level, Ravi and I have agreed that as you look down the road at the day 1 and at year 1, we're not going to touch any customer-facing activities for an extended period of time on the Contract side so that we don't run any risk in terms of defections.

Operator

The next question is from Joe Feldman.

Joseph I. Feldman - Telsey Advisory Group LLC

It's Telsey Advisory Group. Just wanted to ask, first, maybe, Mike, you went through the free cash flow guidance, I think you said would be 0 for this year. At this point, you had to adjust it down. Maybe it just went a little quick for me, but could you just explain again why that would be the case, why it went down?

Michael D. Newman

Yes, it was the increase in merger-related costs. We took it up about $10 million, $15 million.

Joseph I. Feldman - Telsey Advisory Group LLC

Got it. Okay, it was simple as that, okay.

Michael D. Newman

Yes. That's it. The other pieces, and I think if you don't have them, they're the same as we gave last time as far as the guidance on D&A and CapEx.

Joseph I. Feldman - Telsey Advisory Group LLC

Got it, got it, will find that. And then could you guys give a little more color on the new loyalty program and kind of maybe what kind of testing you guys did for it and what the initial read-through has been so far? I know it just launched a few weeks ago, but what kind of gives you some confidence in the new direction of the program?

Robert J. Moore

Yes, this is Bob Moore. I'm Chief Marketing and Merchandising Officer. We did an extensive research on the new loyalty program. We wanted to do bring something new to the market that really gave customers a feeling of connection to our brand. So kind of the key elements, one, we have an element that customers can actually identify themselves as Star Teachers, Local Businesses or Loyal Customers and each of those will be treated differently. We have the same benefit that we had before in terms of the paper, ink, toner and CPD where they get 10% back. But with moving to points, we have the ability for them to earn points in different ways. And for our customers who spend a significant amount of money each quarter with us, they actually can get into a higher level of our program that allows them to choose 5 categories in which they actually get additional savings. So we think it's innovative for the market. We had done extensive testing in comparisons, everything is out there. And initial reaction, as you mentioned, it's only been 3 weeks but is pretty encouraging.

Joseph I. Feldman - Telsey Advisory Group LLC

That's great. And then just one, maybe, I guess, bigger question and a little tougher to get at. But as you guys look at the different components of your business and, I mean, as we've looked at it, what you provide to us, it seems like there are some glimmers of hope that trends are getting better just from a macro perspective. You mentioned small- and medium-sized businesses were actually up, and even it sounds like the school and public business was up, excluding the federal government. So are there things out there that you're starting to see, whether it's borrowing, business formation, just anything that, from a macro, that you guys are maybe not baking in today but are at least thinking that, hey, this is -- we're not as far away as we were a year or 2 ago?

Neil R. Austrian

Everything you just said, that's what we're thinking.

Operator

The last question comes from Anthony Chukumba.

Anthony C. Chukumba - BB&T Capital Markets, Research Division

BB&T Capital Markets. The -- I guess, the joint press release yesterday and then your discussion in of terms the merger integration has been very helpful. I guess what I was wondering is now that you've been working with Boston Consulting Group and you've sort of hashed out the $400 million to $600 million and where it's going to come from, would it be safe to say that you have more confidence now, more optimism that you're going to actually hit the $400 million to $600 million and maybe even go above that now that you've worked with BCG and have kind of detailed where the synergies are going to come from? Is that a fair statement?

Michael D. Newman

Yes, this is Mike. I think the fact that we've been working with Boston Consulting almost 4 months and had a chance to form integration teams with representation from both sides, and they've had a chance to dig into these numbers, of course, we're -- of course, we know more and we've obviously reaffirmed the range. We're going to stick with the range for now and not get out over our skis too much. But we've done a lot of work. Frankly, we've done a lot of work before we got together on this with them. We've done a lot of work together leading up to the announcement and since. So I feel comfortable. And as I mentioned earlier, there's areas like working capital and then, I don't know if it was Colin or Matt who mentioned, potentially, there could be some things in International. There might be some other things we can get at that we have haven't articulated yet, but I personally feel comfortable. The other thing that I really like about this is that we've got people on both sides. The areas that we're going after, particularly the areas in the first year synergies, cost of goods sold, indirect and some of the marketing pieces, we've got people on both sides who are very experienced in terms of delivering these types of synergies. So this isn't a case where you've got 2 businesses who have been focused on other things and then Boston Consulting comes along. This is the case where you've got excellent people on both sides who can implement these synergies, and Boston Consulting is doing a great job. So I feel comfortable with the people. We've been very impressed with the OfficeMax people on the other side and on each team and our counterpart. So I really like how these teams are working together and how we're winding up to deliver these synergies.

Anthony C. Chukumba - BB&T Capital Markets, Research Division

Okay. And then just a quick follow-up question. You mentioned the experienced individuals on both sides who are working on this. I mean, you just had the CFO of OfficeMax leave. I mean, does that set you back at all? I mean, obviously, that's someone would be intimately familiar with where the bodies are buried.

Michael D. Newman

Yes. I mean, Bruce leaving was a surprise. I mean, I think you should ask OfficeMax that question directly. I personally liked him a lot. I think he was excellent. But we have a lot of people working on these teams who are very experienced. We probably have, on our side, 30, 40 people full time; similar on the other side. We've got excellent people on each one of the integration teams. Bruce's leadership and my leadership are important, but it's really the leadership on the COGS team, the supply chain team, the IT team that make this happen. And so while it will hurt us, I think that it's something we can manage, and I think Bruce Parsons will -- or Steve Parsons will do an excellent job replacing him.

Richard Leland

Okay. Everyone, thanks for joining us for the call today. And Mike and I will be available to answer your questions later today. Thanks.

Operator

That concludes today's conference. Please disconnect at this time.

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