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Office Depot, Inc. (NASDAQ:ODP)

Q3 2009 Earnings Call

October 29, 2009 9:00 am ET

Executives

Brian Turcotte - VP of IR

Steve Odland - Chairman and CEO

Chuck Ruben - President of North American Retail

Steve Schmidt - President of North American Business Solutions

Charles Brown - President of International Business

Mike Newman - CFO

Analysts

Chris Horvers - JPMorgan

Mike Baker - Deutsche Bank

Dan Binder - Jefferies

Matt Fassler -Goldman Sachs

Colin McGranahan -Sanford Bernstein

Emily Shanks - Barclays Capital

Steve Chick - FBR

Gary Balter - Credit Suisse

David Strasser - Janney Montgomery Scott

Operator

Good morning and welcome to the third quarter 2009 Earnings Call. All lines will be on a listen-only mode for today’s presentation, after which, instructions will be given in order to ask a question. At the request of Office Depot, today’s conference is being recorded.

I would like to now turn the call over to Mr. Brian Turcotte, Vice President of Investor Relations, who will make a few opening comments. Mr. Turcotte you may now begin.

Brian Turcotte

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

The press release and accompanying webcast slides for today’s call are available on our website at www.officedepot.com. Click on Investor Relations under Company Information.

Office Depot’s Chairman and CEO, Steve Odland will now summarize our third quarter results. Steve?

Steve Odland

Good morning and thank you for joining Office Depot’s third quarter 2009 earnings conference call and webcast. With me today are Mike Newman, Chief Financial Officer, Chuck Rubin, President of North American Retail; Steve Schmidt, President of North American Business Solutions; and Charlie Brown President of International.

Before I summarize our overall financial results this morning, I’d like to share my thoughts on where our business is today. I’ve been very pleased with the execution across the entire enterprise over the past few quarters despite the challenging economic environment. We committed to improving our liquidity and increased it from $800 million in March 2009 to almost $1 4 billion at the end of September. We successfully closed underperforming stores, shuttered non-critical distribution facilities and rationalized unproductive businesses right on schedule. I’m also pleased with the progress made on our key initiatives in each of our three divisions and our business leaders will review that progress in a moment.

Looking at the business I am feeling better about North American Retail right now. As you know, retail was an early indicator of the housing crisis and the looming economic crisis, and first began to decline in early 2008. But we had a good back-to-school season. We continue to gain customers in our loyalty program, and we are beginning to see improving trends in many parts of the country. Unfortunately, California is still lagging for all the reasons that you hear on the news.

North American Business Solutions fell off beginning of December 2008 when the banking crisis began to significantly impact the global economy. However, we grew the size of our customer file again in the third quarter and it appears that the contract channel could start to see some improvement at the end of this year, although the business recovery in California could lag for a while.

Our international business is benefiting from the euro zone being technically out of recession, especially in France and Germany. The UK is still challenged, but the good news is that we are picking up share from our competitors there. The Asian economies are strong and I think we’re very well positioned in India and China to capture the growth in those emerging markets. I’m also excited by the opportunities in Latin America with our joint venture partner. So, I’m cautiously optimistic about a modest recovery beginning in 2010, but obviously, we still have a way to go.

Turning to our third quarter financial results, the total company sales were $3 billion, a decrease of 17% compared to our third quarter results last year. Excluding the impact of foreign currency translation on our international business, the total company sales were down 15%. I should note that the closure of 117 retail stores in North America and 26 stores in Japan since the third quarter of last year contributed to nearly 200 basis points of sales decline.

Adjusted for charges, the third quarter loss was $21 million or $0.08 per share, which exceeded our internal expectations. The GAAP loss of $1.51 per share includes unusual tax adjustments and charges which negatively impacted earnings by $1.43 per share. Mike Newman will discuss the details of those tax adjustments and charges when he reviews our financials later in the call.

We are very pleased that free cash flow and cash flow before financing were $141 million and $145 million respectively for the quarter. These results were driven by strong cash flow from operations of $161 million in the third quarter. Adjusted for charges, total operating expenses decreased by $159 million or 16% compared to the third quarter of last year. This decrease primarily reflects lower payroll and advertising as well as reductions in our distribution costs and fixed asset impairments.

EBIT, when adjusted for the charges, was $18 million positive in the third quarter which is an increase of 20% over the same period last year. So, in the quarter, I am pleased that we exceeded virtually all of our internal projections.

I will now ask Chuck to talk about the North American Retail’s third quarter performance and key initiatives. Chuck?

Chuck Rubin

Thanks, Steve. Third quarter sales in the North American Retail Division were $1 3 billion, down 18% from the prior year, due in part to having 117 fewer stores open in the third quarter of 2009 versus the prior year period. Comparable store sales in the 1,144 stores in the US and Canada that have been open for more than one year decreased 14% versus the third quarter of 2008, and were better than the second quarter as expected. Comparable store sales trends improved sequentially each month within the third quarter.

While transactions were down in the third quarter compared to the same period last year, the rate of decline is holding steady to the second quarter and continues to be better than the previous quarters. A greater contributor to our sales decline in the quarter was a single-digit percentage drop in average order value, though this too is significantly better than the last few quarters.

Consistent with previous periods, the decrease in sales was driven by macroeconomic factors as consumers and small business customers continued to hold back their spending, especially in big-ticket categories, and our commitment to proactively reduce unacceptable margin promotions in select categories.

Within each of the three major product categories of supplies, technology and furniture, we experienced a sales decline compared to the prior year with the largest contributor to our negative comparable store sales being driven by fewer sales with higher ticket, discretionary categories in furniture and technology. Nonetheless, each major product category saw improved sequential trends over past quarters and we did in fact achieve positive comparable store sales in ink and toner, storage in our Tech Depot service offering.

We were pleased with our back-to-school performance. With the majority of schools starting later this year, sales shifted more into late August and September compared to prior years. Our strategy of delaying heavy promotions until key purchasing weeks lowered our comp sales earlier in the quarter, but allowed us to deliver overall improved profitability for the back-to-school season.

Geographically, California and Florida continued to produce the weakest comparable sales trends in the third quarter, and our best performing markets were in Canada, the Northeast and the Midwest. In the third quarter we closed one store, opened one and relocated three, bringing our total North American store count to 1,158 at quarter end.

The operating profit for the North American Retail Division was $35 million in the third quarter of 2009, that’s $23 million higher than one year earlier. The operating profit improvement was driven by a number of factors, including continued improvement in product margins for the fifth straight quarter, a comparative benefit from closing the underperforming stores identified as part of the strategic review, the lower asset impairment charges compared to last year, and reduced operating expenses. These positive factors were partially offset by the unfavorable impact of our sales volume decline that it had on our gross margin and operating expenses.

In North American Retail, we continue to focus on providing innovative products, services and solutions to micro-business customers that will position us well when the economy begins to recover, while continuing to manage our costs. I will briefly update you would on just four of those key initiatives.

First, our product assortment line reviews are going well and the benefits are flowing through as evidenced by our improved product margins over the last five quarters. We expect these product line reviews to continue for the balance of the year, touching many of our current product categories and creating opportunities for additional margin improvement going forward.

Second, our service offerings remain a critical component of our assortment. Our Tech Depot Services business continues to perform well with positive sales trends to last year, and with the recent Windows 7 launch, positions us well to take care of customers’ technology needs.

Third, we had a successful back-to-school season, offering new product assortments with this year’s top trends being Value-Packed Options, Colorful Fun Fashion in technology products like thumb drives. Our commitment was to help parents, teachers and students shop smarter this year by offering the best values. We hosted our annual Teacher Day and displayed our new assortment of products with the Scholastic Teacher set. In addition, we teamed up with Sharpie to launch, “My Project Backpack,” promotion allowing customers to design their own backpacks for prizes including having their backpack design reproduced and sold in Office Depot stores during the 2010 back-to-school season.

Fourth, we continued to make progress on our rent concessions as we work aggressively to reduce our occupancy costs. To-date, we’ve been successful in capturing dollar savings as well as landlord-funded improvements for the physical structures.

In summary, I am pleased that the thousands of North American retail associates that take care of customers every day in our stores continue to make progress with our strategic initiatives. We improved product margins, reduced our operating expenses, launched new marketing programs and improved the product assortment in the third quarter. We also achieved very high customer service ratings as evidenced by our mystery shop scores which were higher than one year ago.

Looking forward, the fourth quarter historically has been lower in both sales and margin mix than the third quarter, but we are cautiously optimistic that the fourth quarter sales rate decline could improve sequentially. With consumer spending still tight and customers demanding great value, we believe this holiday season will be very competitive. However, we will continue to improve our product and service offerings while creating attractive customer promotions that are forecasted to achieve acceptable margins.

As a result, I expect our fourth quarter operating results to be slightly better year-over-year, excluding the negative impact of the asset impairment charges we took last year.

I will now turn it over to Steve Schmidt to review the third quarter results and key initiatives for North American Business Solutions.

Steve Schmidt

Thanks, Chuck. Third quarter sales in the North American Business Solutions division were $880 million, slightly higher sequentially but down 16% versus the third quarter last year. We do believe that the sales decline began to stabilize in the second quarter as evidenced by the third quarter having the lowest year-over-year sales decline in 2009.

In contract, sales to our small to medium-size business customers or SMB, large national accounts and public sector continued to decline in the third quarter on a year-over-year basis. However, the rate of decline from our SMB customers in the third quarter improved significantly compared with the second quarter due to increased acquisition and retention efforts, and despite little evidence of improvement in available liquidity for these customers.

In the third quarter, the sales decline in California worsened and continued to exceed the overall rate of decline for the entire business, while the Florida sales decline was slightly better than the overall rate. These two states continue to represent approximately 30% of the division’s revenue and about one-third of the revenue decline in the quarter.

Although the number of customer transactions and average order value both declined in the third quarter versus prior year, the decline in all channels was principally driven by a decrease in the number of customer transactions. In our large national accounts, we continue to see extreme aggressive pricing being offered by some of our competitors. Our approach has been to exercise increased discipline around the pursuit of accounts that we believe would be sustainable over time.

Overall, we grew the size of our customer file in the third quarter, but new and existing customers are buying less due to the weak economy.

In the direct business, we continue to see the most weakness in furniture, technology and perishables, as customers delay their purchases of durables in favor of consumables like paper, ink and toner. We have not yet seen any indication that this purchasing trend has changed or will change in the near term.

We have seen an increase in demand for cleaning supplies, including sanitizing products, given the impact of H1N1 flu, in addition to normal flu season preparations in both our contract and direct channels.

North American Business Solutions operating profit was $21 million for the third quarter of 2009 as projected, down from $39 million for the same period of the prior year. The drivers of the third quarter operating profit versus last year included the flow through impact of lower sales levels and the negative impact of product margins, including a less profitable product mix and cost increases that were not fully passed on to our customers due to timing issues. Partially offsetting some of the operating profit decline was the continued benefit from reduced selling and G&A expenses.

Despite the challenging business conditions the Business Solutions Division continues to focus on executing initiatives that will position us well as the economy begins what we believe will be a long, slow recovery. Let me briefly review a few of those initiatives.

First, we continue to explore a number of alternative channels to expand our brand. For example, in September, we announced an exclusive partnership with Lil’ Drug Store Products, a leading supplier to the convenience store class of trade, that will enable the distribution of Office Depot branded office supplies for sale in convenience stores throughout the country.

Through this newly formed partnership Office Depot will supply an assortment of more than 25 frequently used office products that are sized and packaged for convenience stores and Lil’ Drug will redistribute those products to convenience stores nationwide.

Second, as a result of the contract sales force reorganization, process changes within the telephone account management organization and the third-party canvassing efforts like, feet on the street, we continue to grow our customer file and acquire new customers. In addition, we continue to focus more resources on our copy and print services offered throughout our 10 regional print facilities in the United States.

Third, we continue to improve the features of the new website we launched in the second quarter, including improved search functionality, a chat feature, customer friendly checkout, and enhanced keyword search. Customer reaction to the new site continues to be overwhelmingly positive.

Fourth, we made significant enhancements to our product catalogs in the third quarter to make them even more customer friendly, including improved pagination, sharper graphics and helpful benefit statements. We also optimized our catalog circulation during the quarter. In the third quarter, 82% of total BSD sales were online, up from the 81% for the same period a year ago and our global company Internet sales for the past 12 months totaled $4 2 billion.

In summary, I feel good about the progress our associates have made in the Business Solutions Division in a very challenging business environment, where the top line results continue to be soft, driven by significant spending cuts across our broad customer base. We continue to tightly manage our expenses while focusing on the key initiatives that will provide growth as the economy slowly recovers from the recession.

Looking forward, although we expect fourth quarter sales to decline sequentially due to seasonality, we expect the year-over-year sales decline to improve versus previous quarters. In addition, we expect our operating profit to improve both year-over-year and sequentially as a result of many of the initiatives we’ve undertaken to optimize our profitability.

Charlie will now discuss our third quarter results and key initiatives for the International Business Charlie?

Charlie Brown

Thanks, Steve, and good morning. The International Division reported third quarter sales of $861 million, a decrease of 16% in US dollars, compared to the third quarter of 2008. Local currency sales decreased 9% with all but a few of the countries in which we operate reporting a year-over-year decline.

The sales rate of decline for both the UK and France has seen improvement, with the rate of decline going from double digits to single digits in local currency, and accounted for about half of the division’s local currency decrease in revenue. The good news is that we are gaining market share in the UK.

I should also note that excluding the impact of closing 26 retail stores in Japan during 2009, our sales decline in the third quarter would be roughly 200 basis points better than the decline experienced in the first half of the year. Similar to what Chuck and Steve have discussed, the global markets continue to face challenging business conditions. In North America, concerns regarding high unemployment levels, reductions in workforce, tight credit conditions and the global recession are having an effect on both business investment and office supply expenditures.

Although we continue being more efficient in keeping our higher value customers, sales in the direct channel declined 10% in local currency, because of continued softness in big-ticket items such as furniture and technology.

Customers have continued limiting their purchases to those essential items as unemployment rates remain relatively high across the division. Contract channel sales continue to be under pressure as well, down 9% in local currency. This sales decline is mostly attributable to larger businesses reducing their work forces and limiting discretionary spend to the core list of office products.

Our International Retail sales were down about 2% versus one year ago, adjusting for our retail store closures in Japan. The International Divisions operating profit was $34 million for the third quarter of 2009, down slightly from the $36 million for the same period in the prior year. The change in division operating profit for the third quarter of 2009 resulted from the flow through impact of lower sales levels, which were almost completely offset by lower operating expenses.

Additionally, changes in foreign currency exchange rates, driven by a stronger US dollar unfavorably impacted operating profit. Although business conditions continue to be challenging, we remain focused on improving our service model and the overall profitability of our business. I will briefly update you on a few of our key initiatives.

First, we continue to focus on strengthening our contact strategy and valued proposition to drive sales and better service the small and medium-size business customer. As part of our move towards a more customer centric approach, we are implementing new pricing strategies and a customer profitability model to improve sales and profitability.

Second, we continue progressing with our SKU harmonization and rationalization program that should be nearing completion. The objective for this program is to simplify inventory management while significantly reducing our operating costs and inventory levels.

Third, our telephone account management initiative has proven successful, resulting in higher retention rates compared to other methods of contacting customers. We plan on continuing this initiative and expanding our efforts in the future.

Forth, we continue looking into expanding our geographic sales footprint There is a great deal of interest in the Office Depot brand and we are creating a portfolio of business relationships globally that fit specific market strategies. For example, we recently signed a franchise agreement in the Middle East and opened our first store in Kuwait, with plans to open more stores in this area. We are also reviewing a number of additional capital efficient opportunities to expand our footprint in Eastern Europe, Asia and South America.

In summary, we reduced costs and streamlined our operations in the third quarter. Our focus on improving customer service is paying off, as we are retaining and reactivating our top customers.

Looking forward, economic data indicates that the recovery has begun in Asia and Europe, but our customers are still reducing costs and finding ways to decrease overall spend, so we don’t anticipate demand changing significantly in the short term.

As a result of our sales growth and cost reduction initiatives, we are optimistic about our fourth quarter performance. We expect our revenue to decline in local currency less than the previous three quarters, and our fourth quarter operating profit could be slightly lower than the third quarter.

With that, I will now turn it over to Mike who will review the company’s third quarter financial performance in detail

Mike Newman

Thanks, Charlie. I would like to start by saying that I am pleased with both our operating and cash flow performance in the third quarter. The performance of our North American Retail and International businesses exceeded our internal expectations and showed positive improvement from prior quarter trends. In the case of retail, operating income nearly tripled compared to last year. Our third quarter free cash flow performance and overall liquidity position also exceeded our expectations.

Regarding the restructuring and liquidity initiatives we have mentioned to you on earlier calls, our execution in these areas has been excellent and delivered significant benefits and cash flow to the business.

In the third quarter, we recognized $40 million of pretax charges related to these actions, which negatively impacted earnings per share by $0.12. For the remainder of 2009, we expect to recognize about $60 million in additional charges as activities are completed and accounting recognition criteria are met.

As a result, at the end of the third quarter, our total company liquidity position was $1.4 billion, the highest level since the third quarter of 2005, and cash at the end of the third quarter was $693 million, an increase of over $0.5 billion from year end 2008. I am very confident that we have ample liquidity not only to take us through this economic recovery, but also to allow us to execute our strategic plan in the coming years.

On cash flow, in the third quarter, our free cash flow and cash flow before refinancing were $141 million and $145 million respectively. Lower third quarter inventories in both Europe and North America had a positive cash flow impact of $96 million. Days sales outstanding were flat sequentially in the third quarter and a three day improvement versus one year ago, and inventory turns improved slightly to 6.4 times.

On cash flow before financing activities, our cash flow before financing activities for the first nine months of 2009 was $360 million. Our outlook for the full year is in the range of $250 million to $260 million, and free cash flow is projected to be in the range of $80 million to $90 million.

Capital spending was $74 million through the first nine months of the year, and we continue to anticipate total year 2009 spending of $125 million to $130 million. For 2010, we expect capital spending to be slightly below our depreciation and amortization forecast of $220 million.

In the third quarter of 2009, we recorded a non-cash tax expense to establish a valuation allowance on certain deferred tax assets totaling $322 million or $1.17 per share, because of the uncertainty of future realizability of these assets.

As a result of this valuation allowance, we also reversed $39 million of tax benefits previously recognized during the first half of 2009. This reversal of tax benefits negatively impacted earnings per share by $0.14 in the third quarter.

Relevant accounting rules require that the deferred tax assets be assessed for realizability for each financial reporting date. The carrying value of those assets must be reduced if future realization is in doubt. A 36 month cumulative pretax income test is one of the criteria used to determine realizability.

Because of the recession and the resulting impact on our results, as well as significant restructuring activities and charges taken by the company in the past year, our cumulative pretax results for the past 36 months became negative for the first time in the third quarter of 2009. As a result, we recorded a valuation allowance against these deferred tax assets and an adjustment for tax benefits recognized in the first half of the year.

Our effective tax rate will be lower and more volatile for some time until we are in a position to remove the valuation allowance in future years.

Regarding the preferred stock dividend, during the third quarter we recorded dividends on our convertible preferred stock of approximately $15 million. You may remember that under this agreement we have the option to pay the dividend in cash or by increasing the liquidation preference on the amount of the preferred stock.

Since our asset-based loan facility does not currently permit us to pay cash dividends, the October 1 dividend was settled by increasing the liquidation preference. Dividends settled like this are recognized at fair value which is currently higher than the amount that would have been due if settled in cash. This fair value captures this current stock price of the underlying common stock as well as the option value of the preferred shares.

Future dividends paid in kind will be measured at fair value, when declared and based on what we know today, we expect the fourth quarter preferred stock dividend to be approximately the same as the third Quarter. But that value should move directionally with changes in our common stock price.

Moving to the balance sheet, inventory totaled $1 2 billion globally, down 19% from the same period last year. This decrease was driven primarily by lower inventory in North American Retail, with inventory per store at $669,000, down 14% from last year. We expect to ramp up per store inventories in the fourth quarter to about $700 000 per store in preparation for back-to-business in the first quarter of 2010.

Please note that we plan to stop reporting inventory per store in 2010 due to the integration of our North American Retail and Business Solutions supply chains, which will make it difficult to accurately calculate inventory per store data. We ended the quarter at $693 million in cash, $134 million increase from the second quarter, primarily due to better than expected operating performance and lower inventory.

Before I can call back over to, Steve, I would like to make a few comments about our fourth quarter outlook. Quarter to-date, sales comps are tracking much better in North American Retail than the third quarter, and the sales rate decline is slightly better in both North American Business Solutions and International in local currency. We typically don’t have a big holiday business and our fourth quarter seasonally ranks third behind the first and third quarters in sales and operating profit contributions.

Last year total company sales were down 15% year-over-year in the fourth quarter and we reported an EBIT loss of about $85 million, excluding all charges. This year, the fourth quarter again will be challenging, but we expect to produce better results versus the year-ago reflecting the benefits from executing on numerous initiatives across the global enterprise.

Our fourth quarter G&A is forecasted to be about $15 million to $20 million higher than the third quarter due to certain change and control expenses that shifted from Q3 to Q4. Despite the fourth quarter challenges and higher G&A, we believe that the current first call EPS consensus looks about right on an adjusted basis, less the impact of moving from a third quarter effective tax rate that’s in the high 20s to a rate of approximately 10% to 15% in the fourth quarter of 2009.

With that, I will turn the call back over to Steve.

Steve Odland

In summary, we are pleased that we exceeded our operating earnings and cash flow expectations in the third quarter and we are encouraged by the progress that we’ve made on strategic initiatives that will provide growth when the economy does recover. As Mike stated, the fourth quarter will be challenging but we are excited about the prospects for our back-to-business season in the first quarter of 2010.

In closing, I would like to reiterate that we remain committed to leading the company through these challenging times and we will continue to do everything we can to provide innovative products and solutions to our valued customers, manage our costs and control our cash flow.

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

Question-and-Answer Session

Operator

(Operator Instructions). Chris Horvers, your line is open for your question. Please state your company name.

Chris Horvers - JPMorgan

Thank you. Chris Horvers, JPMorgan. First a couple of clarification questions. Within Retail International, when you talk about profit outlook for the fourth quarter, were you referring to rate or EBIT dollars in describing your outlook?

Chuck Rubin

Chris, we were talking about EBIT dollars looking slightly better than last year excluding the charge that we took on the impairment.

Charlie Brown

For international, Chris, it’s the same. It’s EBIT dollars.

Chris Horvers - JPMorgan

You mentioned that California seemed to slow down versus third quarter versus the second quarter. What do you think is driving it there? We have heard a lot of retailers talk about better California trends. Then bigger picture on BSD. You mentioned that perhaps contract would start to improve around year-end. What do you see there? Is that largely a comparison issue or something you are seeing in your business?

Steve Odland

I will ask Steve Schmidt to comment on it, but overall, our business in California has not improved and in fact we are worried about it. You know we have a large public sector business out there and the state has been challenged with falling tax revenues and so forth. So they are cutting back at every level in the public sector and that is spilling over into jobs and of course small businesses have been hurt too. So we are just not seeing any kind of recovery in California. Steve will further comment on the turn later this quarter.

Steve Schmidt

I would say that what we are seeing is on a sequential basis is, we are obviously overlapping the business that fell off significantly in the fourth quarter a year ago. It especially fell off in December as the public sector basically shut down, and so what we are seeing and we are forecasting as we go forward and the trends we are seeing in the fourth quarter, we continue to see that year-over-year decline appear to be getting better and so we see that continuing throughout the fourth quarter.

Chris Horvers - JPMorgan

Two more slide-in clarifications. When you mention retail sales much better than ones you’ve posted in this quarter. Is that kind of a minus high single-digit? With consensus in the fourth quarter you’re basically saying first call consensus looks good, a lower tax rate might actually make it look a little better? Is that right?

Mike Newman

Yes, the retail comps quarter-to-date are running in the minus 7-minus 8 range which is considerably better than the third quarter numbers and I missed the second part of your question sorry.

Chris Horvers - JPMorgan

Your comments about fourth quarter or first call consensus number.

Steve Odland

We like the consensus number, but we think you need to adjust for the fact that the fourth quarter tax rate will be in the 10% to 15% range.

Chris Horvers - JPMorgan

Meaning that that number would be higher?

Steve Odland

The loss would be higher, right.

Chris Horvers - JPMorgan

That’s right.

Operator

Our next question comes from Mike Baker. Please state your company name.

Mike Baker - Deutsche Bank

It’s Mike Baker from Deutsche Bank. A couple of questions, three if I could; first, so your CapEx looks like it’s going up next year Mike. Can you tell us where that incremental expenditure is going to be? And what’s the right level going forward?

My next question would be for Steve Odland. Just bigger picture, cautiously optimistic for 2010, GDP looks like its getting better. What kind of economic outlook do you need to be profitable in 2010? I assume you are looking more at employment than GDP because GDP does look like its turning positive, but if you could just articulate some of those economic benchmarks that you are looking for, I would appreciate it.

Mike Newman

This is Mike Newman. I’ll handle the CapEx piece. The increases are driven by a couple areas; one is we have had some deferred maintenance and compliance type CapEx projects because of the tough year we had. So that’s a significant driver. We’re also doing some things in our supply chain both domestically and internationally to drive productivity that we’ve wanted to do, and given the liquidity, we have an opportunity to do that.

We also have a number of items in our strategic plan and the budget that we’re looking at that will drive improvements in our business. Those are the three critical areas that we’re looking at to get our number back. As we said it will still be under D&A, something in the low 200s.

Mike Baker - Deutsche Bank

Is that what we should expect longer term?

Mike Newman

I am not prepared to guide longer term, but I think that as we go forward, until we see a significant recovery, we are likely going to try to keep that equation in place. How long that lasts will be a function of you telling me what the recovery looks like.

Steve Odland

Mike our comments on next year really revolve around lapping the fall-off from last year. So as we now are right about the time that the crisis began, we are starting to see that year-over-year comparison really begin to improve, particularly with our small business customers in retail and in BSD. The large contract customers fell off later. I think Steve mentioned it was December last year, and so that’s why we expect some recovery there.

Sequentially since that falloff last year, you’ve noticed that there hasn’t been further fall-offs. So it’s been sort of pretty stable to normal trends since the fall-off happened last year. That gives me some encouragement that as unemployment begins to peek out and we get some white collar job growth recovery that our business ought to recover as well. So that’s why I think over the course of 2010 I believe that our business [auto] start to recover and then of course profitability should return as we have taken so much cost out of the company and improved the productivity.

Operator

Dan Binder you may ask your question, and please state your company name.

Dan Binder - Jefferies

Dan Binder with Jefferies. A couple questions for you. First your competitors out there this morning saying they expect gross margins to be tougher, assuming that does reflect some of the activity that you talked about in the delivery business. I’m just curious, how you are coping with that, how you are dealing with it, how do you compete against it, and then just curious any early reads or color on the Windows 7 release and how that’s performing and how that’s impacting you both in terms of product and service sales?

Steve Schmidt

This is Steve Schmidt. First of all on the gross margin side, as we look at the whole contract business, the pressure that we see which has been consistent with prior quarters is that as we look at obviously impact of revenue declines and then you combine that with product mix as we continue to see pressure around SMB and then the call out relative to our ability to pass on pricing that’s going on in the marketplace are really the pressure that we are seeing. We have been able to offset some of that through continued cost reduction and focusing on the G&A line.

We will continue to compete, we have a number of initiatives underway to continue to reduce our cost base and optimize the profitability of our customers, as we work through things such as improvement in average order volume, reducing our overall distribution costs and a number of other initiatives that we think will continue to enable us to weather through this tough economic times.

Chuck Rubin

Dan this is Chuck. On the Windows 7, it’s a week-old today as you know. We are pleased with how he came out of the gate on that. We were fully prepared from trained associates in our stores to promotions to product. Across the board from computers to the software to our tech people services in this first week, we’ve been pleased on how it’s been executed and pleased with the traffic we’ve seen in stores.

Dan Binder - Jefferies

Just one last thing; just following up on Chris’s question on the comments regarding Q4. Just so I’m abundantly clear, you are saying that the Q4 number looked fine assuming the old tax rate that we were using, but now will change with the new tax rate?

Mike Newman

We are okay with your guidance, but you need to adjust the tax rate on what we had previously guided in the high 20s to the 10 to 15, which should put pressure, if it’s approximately $0.03 to $0.04 pressure on the EPS number from the lower tax rate.

Operator

Matt Fassler you may ask you question. Please state your company name.

Matt Fassler -Goldman Sachs

Goldman Sachs and good morning. A couple of follow-ups if I could. First of all Steve Schmidt you spoke about a sequential increase in BSD profit dollars in the fourth quarter versus the third quarter. Thinking about seasonality of that business, the past couple years, which I know have not been typical years. The profits have come down quite sharply sequentially. Are we kind of bucking the seasonality trend here or are we just relating to the fact that the past years were very distorted as you looked at the results there?

Steve Schmidt

Obviously last year during the fourth quarter was a very difficult quarter, so we hope as we overlap that to see improvement in that process, Obviously as we close the year I also mentioned that the government sector last year basically closed down, and we saw a huge drop-off in the month of December. While we still expect some decline there, our hope is that it will not be as significant as year ago.

Matt Fassler - Goldman Sachs

My second question is on retail, it’s also a financial question. You gave color on the outlook, you talked about fourth quarter profit better than a year ago, excluding the impact of profit impairments last year. If you could quantify or I guess remind us because I guess you think you probably told us last year what the profit impairments were, and you also spoke about in your release lower impairment charges aiding the retail results in the third quarter of this year. Can you quantify the impairment number of the third quarter too?

Chuck Rubin

The fourth quarter number was about $80 million on the impairment a year ago. The third quarter Matt was on the store impairment, the improvement I don’t have that in front of me. I think it’s 4 to 5. It’s really small Matt, its a few million dollars.

Matt Fassler - Goldman Sachs

When you say $80 million is that excluded from the so-called continuing operations number, because I am working with a store profit number of loss of $40 million a year ago

Mike Newman

As a company Matt we took a loss last year, and I think as a company we backed out about $125 million of charges FAS 144 in stores was the biggest piece in that $80 million range. There was some Citi private label credit card reserves and whatnot that we put up. So a big piece of that $125 million is in retail, somewhere in the $80 million to $85 million range.

Matt Fassler - Goldman Sachs

You give us some color which is very helpful on fourth quarter comps quarter to-date. If you could just remind us what the trajectory was through last year. In other words, at this point in the fourth quarter a year-ago, were you running down in line with the quarter’s average or were things still a bit better than that in October?

Steve Odland

We were pretty close to the quarter average. Matt, just another comment on comps. We fell off last year about September and that was pretty consistent with the rest of the world, and then the comps have been sort of in the high negative teens since then as we have been waiting to lap that. That was the case in July and August. Our comps materially improved in September with back-to-school with sort of a minus eight range, and I think Chuck mentioned that quarter to-date, this quarter, one month in, we are running a minus seven. It seems to be improving a little bit week-to-week on the retail side, which is why I feel better about the state of our retail business. BSD just hasn’t lapped it yet. We are starting to see some SMB come back in BSD, but the large customers dropped off later, and we haven’t lapped that yet. So, it is a little bit encouraging from a year-to-year comparison but it’s still early

Operator

Colin McGranahan, your line is open for your questions. Please state your company name.

Colin McGranahan -Sanford Bernstein

Colin McGranahan of Sanford Bernstein. Starting with retail, just so I make sure I’ve got the right numbers, so backing out, I think we had a $78 million adjustment, so looking at kind of a normalized loss of $41 million in retail last year to work from, is that correct?

Mike Newman

Yes. I have got about $119 million loss last year minus $85 million or so. That’s what I would call the operating loss from last year.

Colin McGranahan -Sanford Bernstein

Then my question becomes, why would it be significantly better than that given that that was easily the worst performance in NAR history in a dramatically step change kind of environment, and historically, the fourth quarter has been a bit more profitable in NAR than the second quarter. In the second quarter this year you had a $13 million negative EBIT. So, I’m just trying to understand why NAR which looked like it had a pretty decent third quarter, it sounds like the trend to-date in the fourth quarter is positive, why it wouldn’t be significantly better than the worst quarter in the history of the segment.

Chuck Rubin

The mix of what you sell in the fourth quarter Colin is different than the second quarter, so we don’t have the same product margin driving the overall profit in the quarter just due to the technology mix. Even though we are being much more conservative on some of the promotional efforts we have had, we still anticipate the product margin to be more conservative than it was in the second quarter

Colin McGranahan -Sanford Bernstein

So, Chuck, it just sounds like you are concerned more on the gross margin line heading into what is still a pretty uncertain holiday season?

Chuck Rubin

It’s uncertain, but we know that technology is historically a larger portion of our sales in the fourth quarter than the other quarters of the year.

Colin McGranahan -Sanford Bernstein

A question for Mike Newman. Just on the cash flow, obviously, a pretty good performance there on working capital, but it looks like one of the big drivers quarter-to quarter was cash from the bucket called accrued expenses and other. It looks like that was the source of about $150 million in cash flow. Can you help us understand what happened there and what was in that bucket?

Mike Newman

I probably have to do that offline. Are you looking at the slide that’s in the investor package?

Colin McGranahan -Sanford Bernstein

No, I’m just looking at my model and trying to understand why the cash flow was so good when inventory was okay and payables coverage ratio was okay and then cash flow was superior, and it looked like it came from the accrued expenses and other line.

Mike Newman

I think a chunk of that is from our restructuring charges. I think there were some accrued expenses impacts in there but the two pieces for me that I over exceeded were the inventory reductions and the fact that our capital was a very lean number, frankly, it was a little leaner than we would have liked it in our CapEx number. We will see that slot back in Q4. That’s why we’re looking to use a little cash in Q4. If that doesn’t suffice, I can get you a better answer and we can have somebody call you back with it.

Colin McGranahan -Sanford Bernstein

Yes, that’s helpful. I’ll follow up with you offline. Then finally a question for Steve Odland. It sounds like you are kind of tentatively wading back into the guidance game or at least looking at where consensus is and expectations are. As you are looking at the world today and the outlook for the economy over the course of the next several quarters, how do you feel about the current consensus number for 2010 of a $0 23 loss?

Steve Odland

I am not deliberately wading back into it. My CFO is dragging me back into it, because it’s very difficult with all the charges and the tax thing this quarter to try to understand it. So, what we were trying to do is just to give a little bit of help because there are too many moving parts to the fourth quarter.

I think at this point let me not comment on next year. I think we’ve got to see some recovery here in the fourth quarter which we expect as I mentioned, but I would like to see that before commenting on next year.

Mike Newman

Colin, I just got a note passed to me that a lot of that explanation on cash flow you just asked about is timing of accrued expenses moving between quarters. That also would contribute to why we are looking for a more modest use of cash in Q4.

Operator

Our next question comes from Emily Shanks. Please state your company name.

Emily Shanks - Barclays Capital

This is Emily Shanks from Barclays Capital. I had a couple of questions about the balance sheet. Specifically, how much cash do you need on hand to actually just run the business itself?

Steve Odland

Normal run the business type cash is in the $100 million to $150 million range. We’re actually in the process of implementing a global treasury workstation that we think will be able to reduce that and be more efficient going forward. I’m not going to qualify that until I see the analysis of how that system will work, but that should -- that system should free up excess cash in the system and allow us to use that. Right now, $100 million to $150 million is a good proxy. So, if you’re looking at $700 million balance, that balance is clearly free and available to the business.

Emily Shanks - Barclays Capital

Okay. What are your priorities with that excess balance?

Steve Odland

The priorities on the excess balance are that, obviously, we do not have any debt coming due. We’ve looked at increasing our CapEx to a point where we think that’s prudent in the type of year that we are recovering, we’re starting to get it, some of the deferred maintenance and strategic investments we’re making in supply chain and other parts of our strategy. After that, the balance is just going to sit there.

Emily Shanks - Barclays Capital

Just one clarifying point. In addition to the charges of $40 million which you provided in the details of the Q, there was also an indication that there was a $6 million non-cash loss related to the disposition of other assets. What line item in the P&L is that in?

Mike Newman

I’m a little puzzled as to what you are referring to.

Emily Shanks - Barclays Capital

I’m happy to take it up offline if it is easier, but there was an indication in the Q that in addition to that $40 million of charges that you took, there was also a $6 million non-cash loss.

Mike Newman

We exited a Canadian business in Q3 that had a minor charge. That’s what that is.

Emily Shanks - Barclays Capital

Where is that in the P&L?

Mike Newman

We will have to call you back with the details. I don’t have that off the top of my head.

Emily Shanks - Barclays Capital

Okay, that’s great. We just want to make sure we are giving you enough credit on the add backs. Thank you.

Mike Newman

We’ll get an answer for that.

Operator

Steve Chick, your line is open. Please state your company name.

Steve Chick - FBR

Thanks. FBR. I wanted to ask to Charlie and/or Steve, that you guys mentioned twice or so I think about market share gains in the UK within your International Division. I was wondering if you could speak to that a little bit on kind of what you’re getting at, what’s going on there, and if it’s within the contract or the direct channel that you are talking about?

Charlie Brown

As you know, tracking share in our industry, particularly internationally is very difficult. However, what we’ve been doing over the past 18 months or two years, as we put a full-court press on our execution, and I’m talking about the end-to-end delivery process, we have seen our customers really our ability to grow our customer file has increased. Now how we track this is by looking at product categories, and looking at shipments of the ink and toner in total which we can get from our suppliers or looking at how our share of that has moved similar to paper and other classes. So we think that it’s actually very positive and it’s coming from superior execution, and it’s both contract and direct

Steve Chick - Friedman Billings Ramsey

That’s a pretty concentrated market with I guess there’s two primary competitors that you are kind of facing there or do you think that you are taking away from all of those that aren’t as large?

Charlie Brown

There’s two large global players as you would know, but what we’ve seen is a number of the smaller dealers and suppliers have actually closed shop. So we can’t tell who we are taking it from. We can just tell that our rate of growth is exceeding, the rate of growth of the channel itself.

Steve Chick - Friedman Billings Ramsey

Can you remind me, the UK as a percentage of your international business, is it pretty large is it?

Charlie Brown

I think we’ve disclosed that in the past, I think it’s about one-third of our sales, yes.

Steve Chick - Friedman Billings Ramsey

Second, if I could Steve, the BSD sales trends that you have talked. Well you gave granularity on the retail comps and they are getting better sequentially here today in the current quarter, and I was wondering if you could give a similar type of percentage declines that you are currently seeing within BSD

Steve Schmidt

We didn’t talk specific figures other than what we talked about was the fact that we are seeing the year-over-year decline improving, as we go through our current business and as we forecast into Q4. Again just to recall, our business significantly fell off in December, a year ago, as the public-sector shut down. So as we overlap those numbers, we are forecasting a continuous improvement in year-over-year declines as we go through the fourth quarter

Operator

Gary Balter you may ask your question. Please state your company name.

Gary Balter - Credit Suisse

Gary Balter from Credit Suisse. First question is just a clarification from my side The preferred stock you explained in the 10-Q why it’s a $15 million accrual rather than $9 million of interest (inaudible) is there dividends payable on the $15 million going forward or is it always on the $350 million only?

Steve Odland

It is on a $350 million and there’s two pieces to the $15 million calculation There is really a piece that is, if you will, a par value calculation on this (inaudible). The other piece is essentially a - we don’t use Black-Scholes but it’s another methodology to calculate the value of that option and that’s the bulk of the $6 million difference.

Gary Balter - Credit Suisse

Right, you explained that the 10-Q, but my question is like now that we have a balance of $365 million is the 10% accruing on the $365 million or is it always on the $350 million?

Steve Odland

Your question is there a knock-on effect on the dividends on the dividend? Yes.

Gary Balter - Credit Suisse

Second is on retail, help us think about it, because productivity is about 30% below where it was in 2006 and that’s not different than many other companies obviously in what’s going on. So it’s not a knock on your retail business. But what type of operating margins given the productivity levels that you are achieving should we be thinking about are doable down the road?

Chuck Rubin

Gary it’s Chuck. I think we can get back into single digits. A couple years ago we had gotten very high, but we’ve restructured how our store operates and the cost structure in that, we’ve made progress on our product margins, we need to stabilize on the sales and start to see comps improving, and we can get into good single-digit operating margins.

Gary Balter - Credit Suisse

You are in single-digit operating margins today. Your operating margin in the quarter was nearly 3%.

Chuck Rubin

It’s almost 3%

Gary Balter - Credit Suisse

But you are thinking 5% to 6% range upon recovery here right? In the quarter just following up on a question Matt asked last year you specifically outlined $21 million of one-time charges in the retail so that brought it to $33 million, and I think you answered it but I wasn’t clear on the answer. What were the charges within the operating number this year for retail?

Steve Odland

Hold on one second here. You are asking Gary what were the charges in Q3 in this Q3 in the operating?

Gary Balter - Credit Suisse

In retail, because you mentioned lower charges or lower whatever you call them.

Steve Odland

So that was lower store impairment than last year. It was in the single-digit millions, I can’t place an exact number.

Mike Newman

I want to say, it’s not material, it’s less than $5 million I don’t have the number off the top of my head. I want to say its $3 million to $4 million.

Steve Odland

Versus the $78 million last year.

Brian Turcotte

I think we have time for one more call, so why don’t we take one more.

Operator

Our next question comes from the line of David Strasser. Your line is open sir. Please state your company name.

David Strasser - Janney Montgomery Scott

Janney Montgomery Scott. It’s about inventory; you had talked about sequentially improving inventory into next -- into the fourth quarter. As you are thinking about it towards next year, on the inventory per store I guess I was focusing on. Is that number going to continue to go up? How do you feel about inventory per store? Do you think it’s too low where you were this quarter or just what do you think the appropriate number is as you go into 2010?

Chuck Rubin

Just to clarify, I think that we said that the inventory per store is going to be a little bit higher at the end of fourth quarter than it was at the end of the third quarter.

David Strasser - Janney Montgomery Scott

I was thinking out, but I don’t know how much of that is just seasonally related. I’m just trying to get a sense from a broader picture of where you think that could be

Chuck Rubin

I think that inventory levels that we are running are approximately correct. You know we’ve been much more efficient in how we’re using the inventory, and I think Mike called out in his comments that we are not going to report store inventories next year as we consolidate our retail and our BSD supply chains. That’s going to help us be more efficient with our inventory in store and keeping in-stocks very high, without actually layering in a lot of extra inventory dollars into those stores. So I think somewhere in that $700,000 per store range is going to be about the right level

David Strasser - Janney Montgomery Scott

I understand what you are saying about it, you not giving in next year. Okay, so I guess where you are at, when you as a consumer walking through the store right now you are comfortable with where the inventories are? I guess there could be differences within the supply chain and so on.

Chuck Rubin

Generally yes, our in-stocks are very high, the cleanliness of our inventory in terms of end-of-life inventory is very clean. So I feel pretty good about where we are overall.

David Strasser - Janney Montgomery Scott

One last thing if I missed it I apologize. After the conversion what is share count roughly for Q4?

Steve Odland

Yes 274 is used in the calculation and it is done on two basis depending on which is more dilutive. The calculation that we are using is 270, and on an as converted basis, if the convertible preferred were converted there’s another $70 million, $71 million now after the dividend shares that would be in the calculation, but I think we are still on the basic calculation right?

Mike Newman

274 for the fourth quarter.

Brian Turcotte

This concludes our conference call this morning. Please note that we will be updating our supplemental investor presentation in the investor relations section on our website that provides additional information on the company. Thanks to everyone for participating in the call.

Operator

That does conclude today’s conference, you may disconnect your lines at this time.

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Source: Office Depot, Inc.Q3 2009 Earnings Call Transcript
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