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Staples, Inc. (NASDAQ:SPLS)

Q3 2009 Earnings Call

December 1, 2009 8:00 am ET

Executives

Laurel Lefebvre - Vice President Investor Relations

Ron Sargent - Chairman and Chief Executive Officer

Mike Miles - President and Chief Operating Officer

John Mahoney - Vice Chairman and Chief Financial Officer

Demos Parneros - President US Stores

Joe Doody - President North American Delivery

Analysts

Dan Binder – Jefferies

David Strasser - Janney Montgomery Scott

Mike Baker – Deutsche Bank

Chris Horvers – JP Morgan

Gary Balter – Credit Suisse

Brian Nagel – Oppenheimer

Matthew Fassler – Goldman Sachs

Stephen Chick - FBR

Colin McGranahan – Sanford Bernstein

Anthony Chukumba – FTN Equity Capital

Joe Feldman – Telsey Advisory Group

Alan Rifkin – Bank of America

Mitch Kaiser - Piper Jaffray

Operator

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

Laurel Lefebvre

Thanks for joining us for our third quarter 2009 earnings announcement. During today’s call, we’ll discuss some non-GAAP metrics, to provide investors with useful information about our financial performance. Please see the financial measures and other data section of the investor information portion of Staples.com for an explanation and reconciliation of such measures and other calculations of financial measures that we use to analyze our business.

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

Here to discuss Staples Q3 performance and business outlook are Ron Sargent, Chairman and Chief Executive Officer, Mike Miles, President and Chief Operating Officer, and John Mahoney, Vice Chairman and Chief Financial Officer. Also joining us are Demos Parneros, President of US Stores, and Joe Doody, President of North American Delivery.

Ron Sargent

I’m pleased to report encouraging trends throughout our business. During the past several quarters we’ve stuck to a simple plan of providing great customer service, carefully managing our expenses, and continuing to invest in growth. The good news is that this plan is starting to pay off and we’re feeling increasingly optimistic about the future.

Integration of Corporate Express is very much on track in both North America and in Europe. In North American Retail our efforts to grow services and technology are working. We drove positive customer traffic during the quarter and the great news is that we got the business back to flat comps. In North American Delivery our small business customers are also gaining strength with the top line trend continuing to improve in our catalog business.

While this progress is encouraging, some challenges do remain. We’re winning new customers in our contract business but sales from existing customers are still weak and we’re not yet seeing the top and bottom line improvement we’d like to see in the contract segment. In our International business we continue to face a difficult sales environment in most geographies. Weak results in China and very tough trends in our printing systems business in Europe.

In terms of the headlines; total company sales for the third quarter were down 6% versus last year to $6.5 billion. Adjusted earnings per share declined 7% to $0.39. Year to date, based on strong Q3 results we’ve achieved record free cash flow of $1.4 billion.

Before we discuss our business units in more detail I’d like to thank all the Staples associates for your hard work as well as their performance. As I’ve traveled around the country and around the world this year to meet with people in our stores and delivery operations I’ve been very impressed to see how focused our team is. Our morale has remained very high throughout the recession as we continue to win with customers. I’m really proud of our team’s efforts to deliver solid operating results.

Now turning to our business units and we’ll start with North American Delivery. Sales for the third quarter were $2.5 billion, down about 11%. In Contract our top line trends were stable with year over year declines in the low double digits. In Quill, top line trend was similar to last quarter with year over year declines in the high single digits. In Staples Business Delivery we saw good sequential improvement in the top line trend with year over year declines in the mid single digits.

NAD operating margin of 8.9% was flat compared to the same period last year. Synergies from better buying and combining two sales forces, savings from closing warehouses, and improved processes across our combined fulfillment center network all helped operating margin. On the negative side, Contract customers continued to buy more on-contract lower margin products and fewer discretionary items. While this trend is moderating somewhat, its been moderating throughout the year, it continues to drag on gross margin. Higher incentive compensation also weighed on NAD profitability.

Our Contract offer continues to strike a cord with customers, we’re winning a lot of new business without having to make significant price concessions. Customer acquisition and retention were strong across Contract, Staples Business Delivery, and Quill but sales from existing customers remained negative particularly in Contract where sales trends are closely tied to employment.

Facilities and break room supplies, the largest of our lines of business performed well, helped by higher sales of flu related products. Our more discretionary lines of business like promotional products and furniture remained weak with year over year declines in the double digits.

We’re also doing a great job with our key operating metrics in Delivery including our perfect order metrics and average order size. When we acquired Corporate Express the average order size was about $160 compared to Staples average order size of over $220. Today the average order size for Corporate Express is at $180. We’ve also done a nice job driving down small orders and have decreased the percentage of Corporate Express orders under $50 by several hundred basis points.

The integration of Corporate Express in North America is going very well. During the third quarter we completed our 2010 full line catalog which will begin shipping to customers this week. This catalog features one common product assortment of 8,800 items. We’ve converted more then 1,000 items from Corporate Express brand to Staples brand.

In terms of integrating our fulfillment center network we’re now testing our first warehouse in North America that will fill orders from both legacy Corporate Express and Staples customers. More broadly, our supply chain strategy is to take the best of both worlds by combining some of Corporate Express key capabilities like outbound transportation and route optimization tools with some of Staples existing capabilities like warehouse management and replenishment systems.

Moving on to North American Retail, in Retail, sales for the third quarter were $2.6 billion which was an increase of 1% versus Q3 of 2008. The Retail teams in the United States and Canada have done a great job getting the business back to flat same store sales. We drove a 400 basis point sequential improvement in the two year comp trend with a monthly trend improving steadily throughout the third quarter.

Traffic was strong, customer count comps increased 2% compared to Q3 2008. This was the first time we’ve seen positive customer traffic in nine quarters. Although the average order size is improving sequentially it was still negative compared to last year that was down about 2%.

We drove positive comps during our Back-To-School season as expected. Our customers had an appetite for great deals. We managed our promotional strategy and we increased our focus on computing solutions, driving strong performance in both supplies as well as technology. We differentiated our offer from other retailers with a broad assortment, great in stock levels throughout the entire season, and excellent customer service. We also achieved strong customer service scores during the challenging highest traffic weeks of the season.

We’re encouraged by the very strong trends in growth areas where we’ve been investing throughout the recession. Our initiatives to drive core categories like ink and cut sheet copy paper continued to delivery positive comps. As we focus on selling technology profitably we achieved strong double digit comps in laptops and protected the bottom line by paying close attention to attachment rates.

We also continue to see triple digit growth in our high margin Easy Tech business, the release of Windows 7 fueled very strong top line trends during the last 10 days of the quarter. We estimate that this probably helped our third quarter same store sales in North America by a little less than a point.

On the copy and print side, our stand alone shops delivered strong comps and our copy centers across the chain saw nice improvement in the top line trend as customers responded to promotions like 50% back in rewards. Despite these positive trends, demand for durables like business machines and furniture remained weak.

North American Retail operating margin declined 19 basis points to 10.1% as the team managed the P&L very tightly. Gross profit continues to benefit from the purchasing synergies we’ve realized but these were more then offset by the increased mix of lower margin technology products, as well as modest de-leverage on the rent line.

Computers accounted for more then 9% of NAR sales during the third quarter versus 8% for the same period a year ago. We did a good job with operating and selling expenses, particularly in marketing where we’ve been able to reduce costs by moving more marketing online while carefully managing printed circular costs.

We also had excellent results in shrink at a time when a lot of retailers are seeing that number trend in the wrong direction. These improvements were offset on the labor line as we continue to invest in our services business. Incentive pay for associates was also higher as the team drove better results. We did a great job managing working capital and we reduced inventory per store by 8% compared to last year’s levels.

Looking ahead to the holiday season, we’re planning for a better sales environment compared to last year. In 2008 we pulled back on marketing spend and promotional activities in response to a pretty bleak retail environment but this year we’re going after holiday sales and we’re focused on saving customers money on technology products.

In addition to great deals on gifts, we’re also running traffic driving promotions on key items like ink. With Black Friday just a few days ago its still a little early to make a call on the holiday season but we’re confident that we’ve got the right offers for our customers this holiday.

During the third quarter we opened three stores and we closed three stores in North America. We ended the quarter with a total of 1,872 stores. We entered nine new major markets since the beginning of 2008, opening stores in Minneapolis, Houston, Austin, Kansas City, San Antonio, Omaha, Las Vegas, Tucson, along with our first store in Louisiana.

These stores have opened very well and we’re being extremely selective with new real estate by only picking the very best opportunities. We expect to open about five stores during the fourth quarter for a total of about 50 new stores in North America for the full year. Looking ahead to 2010 we’re going to continue to open a store week in North America, about the same as this year.

Our real estate strategy includes using our various store formats to fill in markets where we already have stores while at the same time looking to enter the remaining major markets where we don’t have any stores. We still don’t have a single store in about 10 of the top 100 US markets and we plan to go after those markets as well.

With that I’ll turn it over to Mike Miles to talk about our International business.

Mike Miles

Sales for the third quarter in International were $1.4 billion down about 10% in US dollars and 12% in local currency compared to the same period last year. Operating margin came in at 2.8% of sales a decrease of 71 basis points from Q3 2008. Europe office products performance was fairly good with mid single digit operating profits and margin expansion in the Delivery business. However, challenging market conditions in our Printing Systems Division in Europe and continued weakness in China drove the overall margin down and together those two represented a operating loss of nearly $20 million.

In Europe, Contract sales were down in the high single digits but margins improved despite softer sales as a result of the early synergies that we’re achieving. In Catalog, we enjoyed strong sequential sales and margin improvement with top line benefiting from strong demand for facilities and break room supplies, particularly in flu related items.

Our European Retail business had slightly negative traffic with same store sales down 9% driven by weak sales in the Netherlands and Portugal where we have high mix of technology products. The UK and Germany fared better with comps down in the low single digits. Across European Retail we had positive comps in ink and relative strength in office supplies. As a result, profitability for the Retail segment remained strong with margins down just modestly despite a sales decline in the single digits.

We’re making steady progress with the integration of Corporate Express in Europe and we’re close to completing our vendor negotiations. We’re applying the same methodologies that yielded significant synergies in North America to what had been a very fragmented buying effort so we expect to see good results for our 2010 vendor agreements.

We’ve gotten through the bulk of our Works Council discussions which will lead to significant G&A savings. We’re rolling out the Staples brand across the continent from re-branding of trucks and stores to repackaging our own brand products to putting the Staples name on our catalogs. We also continue to consolidate our warehouse network across Europe. In the third quarter we consolidated our warehouse operating in Italy and we’re on track to complete three more warehouse projects during the fourth quarter. By year end we will have close 10 such facilities since the acquisition.

Outside of Europe, Corporate Express Australia did a great job maintaining profit margins in a tough environment. Our business in South America drove nice top line growth and improved its profitability significantly year over year, closing in on break even. In China, we continue to face declining sales and steeper losses as we work hard to strengthen our team, our business model, and overall execution.

Before wrapping up I thought I’d provide you with some of my early observations and discuss what I’ve been focused on since I took responsibility for the International business about three months ago. Since September 1st I’ve been to all five continents that have Staples operations. There’s tremendous energy toward making Staples the premier global office products brand, and lots of interest in the success formula that has driven our results in North America. We have very good leaders in place all around the world.

I’m focused on three priorities:

Getting the people side right, establishing the right structure, ensuring that we have no redundant overhead, and developing the team over time.

We have to prioritize the countries in our portfolio that can yield profitable growth. We’re in 25 countries in International. Some of those countries are even more profitable then North America, some of those countries have consistently lost money. We will look to invest and accelerate growth where we can build a strong position and will not hesitate to pull back from markets where we cannot earn a profit. We’ve already consolidated our business in Hungary into other European operations and during the fourth quarter we’re planning to close our two Office Center stores in Germany.

We have to make the International business more profitable. For the last several years we’ve talked about a 7.5% margin goal for Europe but we’ve made little progress. We’ve got to change that. With the acquisition synergies and the other cost reductions we have in the works we intend to take an important step forward on profitability in 2010.

Now I’d like to turn it over to John to review our financials.

John Mahoney

Our third quarter GAAP earnings per share on a fully diluted basis increased 68% to $0.37 versus the third quarter 2008. Excluding pre-tax integration and restructuring expense of $16 million during the third quarter this year as well as the $132 million of pre-tax integration and restructuring expense and the $57 million tax related charge we took in Q3 2008 our adjusted earnings per share declined 7% to $0.39 versus the third quarter 2008.

The foreign exchange impact of our weaker US dollar was a modest benefit to the top line of about 50 basis points during the third quarter. Gross profit margin improved by 28 basis points to 27.1% this reflects stronger product margins driven by purchasing synergies as well as efficiencies and delivery expense, partially offset by a higher mix of lower margin technology sales and de-leverage of rent expense in our retail business, as well as pressure from more on-contract purchases in Delivery.

SG&A de-levered 37 basis points versus last year’s third quarter to 19.3% of sales. This decrease was driven by de-leverage of fixed costs on lower sales as well as increased incentive compensation, somewhat offset by integration synergies and marketing efficiencies. Excluding integration and restructuring expense, adjusted operating margins declined 10 basis points year over year to 7.4%.

Capital expenditures came in at $61 million for the third quarter down from the $75 million we spent in Q3 2008 as we continued to invest prudently in growth ideas. With robust operating cash flow of $889 million for the quarter we generated third quarter free cash flow of $828 million. Year to date we’ve generated record free cash flow of $1.4 billion compared to $921 million during the same period last year. We expect cash flow will remain strong, however, potential inventory investments to support our improving sales trends may limit working capital improvement.

To update you on our capital structure, we reduced our debt by $400 million and ended the third quarter with a little less than $2.6 billion in total debt. Since we acquired Corporate Express we’ve reduced our debt by just over 40% or by $1.9 billion. As our balance sheet continues to strengthen, our priorities for cash remain the same. First, we’ll invest in new growth ideas. Second, we’ll focus on maintaining a strong credit rating to ensure our financial flexibility, and Third, we’ll return excess cash to our shareholders.

During the third quarter we saw some stabilization in our business. As a result, we feel comfortable providing sales and earnings guidance for the fourth quarter. We expect total company sales to increase between 1% and 3% in US dollars or to decrease in the low single digits in local currencies versus the prior year. We expect adjusted earnings per share excluding integration and restructuring expense in the range of $0.36 to $0.38 for the fourth quarter 2009.

To give you some more detailed guidance for the fourth quarter 2009 we expect depreciation expense to be $105 to $115 million in the fourth quarter and $440 to $450 million for the year. We anticipate amortization expense to be $25 to $30 million in the fourth quarter and $100 to $105 million for the full year. Integration and restructuring expense is expected to be $20 to $25 million in the fourth quarter and $85 to $90 million for the year. Net interest expense is expected to be $55 to $60 million in the fourth quarter and $230 to $235 million for the full year.

In terms of share count, you should expect about 730 million shares for the fourth quarter. Finally, we’ve done a good job carefully managing capital this year. We now expect to spend about $325 million in capital in 2009 versus our previous guidance of $350 million.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Dan Binder – Jefferies

Dan Binder – Jefferies

On your comments regarding holiday sales and going after holiday sales, would you imagine that its sounds like they might be a little bit more promotional activity behind that. Would you anticipate that being supported by vendors or would it impact your gross margin? Secondly, if you’re willing to give us any kind of color on how the Thanksgiving Day weekend went that’d be helpful. Finally, on Corporate Express and the synergies related to those efforts I was curious what the odds of getting more then $300 million in synergies once the important distribution center integration is completed if it goes well?

Ron Sargent

Holiday sales, I think just a completely different world this holiday season then last holiday season. It seemed like consumers had gone home last year. I think this year they’re probably in a little more of a tendency to do some shopping. I think it probably will be a pretty promotional holiday season. December is always promotional, its typically high technology mix. I think we’ll certainly spend some more in various marketing vehicles but I think also we’ll also be looking for our vendors who I think are anxious to spend some more as well.

We do think holiday is going to be better this year then last though I should caution you that January is our most important time of the year because that’s when the mix really changes over to back to business and office supplies where there’s a lot more margin in office supplies then there would be in the technology side. In terms of Black Friday, Demos has been living through that for the last few days so let me ask Demos to answer that one.

Demos Parneros

A few comments about Black Friday, first the short answer is good day for us. We had an aggressive plan for Black Friday and I’m happy to say that we delivered on the plan. Again, more aggressive plan then last year as Ron mentioned last year was pretty depressing from Black Friday through the December season and beyond. Good day on Friday. I was encouraged by the strength of the day beyond the morning deals that usually dominate the day. The weekend was actually pretty balanced for us. Good news on the Black Friday weekend.

The only other thing I’d add to this is that we’ve never really been able to determine that a good Black Friday equals a good December so to me the game starts all over again and December is another challenge for us to face, as Ron mentioned we are ready with a little bit more aggressive plan this year then we had last year.

Ron Sargent

For your last question I’ll ask John Mahoney to talk about the Corporate Express synergies and whether there’s upside to the $300 million that we’ve talked about.

John Mahoney

We’ve said before the synergies were really what we planned when we made the acquisition and largely represent the cost improvements that we expect to see as a result of the areas of better buying, overhead, and some of the initial operational improvements. As we get down the road, as we are now, it becomes harder and harder to identify the difference between operating improvements and synergies. I think that we should really look at the operating margin in NAD as a benchmark for how we’re doing in NAD. In the US in particular we’re so far down the road in terms of putting the two businesses together that its difficult for us to even distinguish between Corporate Express and Staples business at this point.

Operator

Your next question comes from David Strasser - Janney Montgomery Scott

David Strasser - Janney Montgomery Scott

Can you talk a little bit about, you talked about the promotional environment what you were anticipating I was just curious what you saw relative year over year on Black Friday or through the weekend? Number two, on the International business the two areas that seem to be problematic, at least to profitability, were China and the printing systems business. Any thoughts on what to do with the printing systems business, is it fixable or do you look to maybe sell it or do something along those lines? On China, what type of timeframe can we look at for profitability and what are some of the key opportunities there to make that happen?

Demos Parneros

Black Friday promotions I would say were very aggressive this year as they were last year. The thing about Black Friday is that everyone is a player on that day and the mass players in particular are out there very strong for us. Everyone competes with the categories that we’re selling. Whether it be PC’s where there were probably five or six different offers out there or things like GPS there were probably 15 different retailers out there, not to mention the online offers. I would say it was as aggressive as a year ago.

As far as the weekend its a little tough to tell how the strength held up for various people as we mentioned before ours I thought was good throughout Saturday and Sunday as well but couldn’t comment on the others.

Ron Sargent

I’ll take China, then I’ll ask Mike to talk about the printing business in Europe. I was just there in China a few weeks ago so I’m probably better equipped to answer that one. First of all, China is not significant to our total results but having said that our China business has struggled this year. We’re not a bit happy about it.

Until last year I think China had been a very successful entrepreneurial venture but I believe we started to place too much emphasis on sales and not enough emphasis on profitable sales. I believe in China that we have focused on too many initiatives there rather then really focusing on the basics. The basic is selling office supplies to business and government customers.

Additionally, I should point out that our gross margins are low there in China because of our aggressive expansion into new markets as well as into several new businesses. I think the focus right now is to instill a lot more process and a lot more overall discipline to make the China model work. We continue to think that China offers a tremendous opportunity for growth for the company as well as profitability for the company. We certainly plan to be very successful there.

We think that the team is very good in China and that the addition of a lot of new talent which we’ve imported over the last six months or so is going to get us back on track in China. In terms of timing for profitability, every time I pick a time you guys write it down and then you’ll mention it to me later. Do I expect to break even in 2010, I probably don’t expect to break even in 2010 but certainly we’re going to make huge progress over the next year, 2011 I’ll be disappointed if we’re not making money in China. That’s my timeline and I’m sure you’ll bring it up in about two years.

Mike Miles

To refresh everybody’s memory the Printing System Division in the sales and service of [Heidelbrook] Printing Equipment. Its actually not a bad business but its a very cyclical business. As you can imagine, in this kind of environment its about as bad as that business has ever seen it. Most of the expenses in that business are in salaries and as you know in Europe those are mostly fixed. Even though its 10% of our European business overall it represents more then half of that $20 million loss I referred to.

As I say, its not a bad business and we’re taking steps this year to right size it, that’s added some expenses, we’ve done some severance. I think even though we won’t see much of an improvement in the top line for PSD next year we should have a lot less of a drag on earnings from that business because of the actions that that management team has taken in 2009.

David Strasser - Janney Montgomery Scott

Do you think its a core business going forward for you?

Mike Miles

Its hard to say that it fits neatly into our core. Its obviously not in the office products business by any stretch of the imagination. By the same token this would be the absolute trough of the business. I think our focus right now is on getting it back to profitability.

Operator

Your next question comes from Mike Baker – Deutsche Bank

Mike Baker – Deutsche Bank

Starting on North American Retail, you said that Windows 7 helped by a little less then a percent that’s over the entire third quarter?

Ron Sargent

Windows 7 launched the last 10 days of the third quarter so it helped us about a little less then a point on the comp line the last 10 days.

Mike Baker – Deutsche Bank

I assume that that continues into the fourth quarter is that fair to say?

Ron Sargent

I think you have a big surge when a product like this is introduced. I think it looks to me like its going to be a pretty successful product line for both software and hardware.

Demos Parneros

I think the initial bump was there and then I think as the product is now integrated into the new hardware the dust settles a little bit. The good news, what’s happened is that its been better accepted then people had anticipated so we had the nice improvement up front. We take it and go from there.

Mike Baker – Deutsche Bank

Your fourth quarter sales guidance even when you take out the currency does call for about a 300 to 400 basis point improvement, something in that range. Is that coming on Retail, Delivery, or International, or all or one more then the other?

John Mahoney

As we said, we see some more stability in the business overall but I wouldn’t tell you that the visibility by channel is as precise as we might like it to be. We really don’t want to be any more specific by channel in terms of what we think about overall guidance. I think what was said is about what we’re willing to say on guidance for the quarter.

Operator

Your next question comes from Chris Horvers – JP Morgan

Chris Horvers – JP Morgan

That was a good segway into my next question about the fourth quarter. The sales outlook is clearly I think above what everyone expected and very strong and very encouraging, versus what I was modeling and I think others were modeling. The margin flow through I would have expected it to be higher given the outlook for the top line. Can you talk about how the pressures from International could persist into the future specifically the fourth quarter? Is it the expectation on the promotional environment and Retail is also impacting you, the on-contract purchasing? Maybe buck it out those pressures and how they’re changing over time.

John Mahoney

The International office supplies business in Europe has been reasonably stable, the demand environment isn’t great in Europe but overall the team is doing a good job and we believe that as we’ve gotten some of the worst council discussions behind us and making progress that Europe is going to start to see some improvements. I wouldn’t look at Europe as a drag on our business.

I would say though that as we are starting to see opportunities we want to be sure we invest in them so that we gain market share and that’s true both in NAD where the direct marketing businesses Quill and SBD are both seeing opportunities and in Contract where as we do continue to see weakness in existing customers sales and we do continue to see pressure on margin with the on-contract purchases we don’t expect to see a big improvement there.

In the Retail business we’ve talked about the success we’ve had with the copy and print initiative, the technology initiative and the office supplies renaissance so I think that the earnings flow through reflects the fact that with a more stable revenue environment we’re going to continue to do the things we need to, to be able to come out of this with higher market share overall.

Chris Horvers – JP Morgan

Does the incentive comp pressure that’s just the result of the stores and NAD being above plan, is that something that the third quarter was a catch up in terms of accrual that that might not persist into the fourth quarter?

John Mahoney

No, I think the incentive comp continues to be something. We accrue it ratably our first and second quarters being lower volume quarters don’t attract nearly as much of the incentive comp as the third and fourth quarter do where we make a lot of money. The fourth quarter will continue to see incentive comp as an expense that’s higher then clearly over last year, last year we paid no bonus so we’ve got substantial increases in accruals.

Chris Horvers – JP Morgan

On the on-contract purchasing, is that something, you mentioned that it moderated 3Q versus 2Q is that a function of comparisons and as we look forward do you get to a point where the comparison makes it such that that won’t be a pressure?

Ron Sargent

Yes, I think obviously the world changed about nine months ago so I think once you get through that one year cycle things look better. The impact was 50 basis points in the first quarter, it was 30 basis points in the second quarter, and I think it was 25 basis points this quarter. I do think it is moderating and will continue to moderate, particularly after the fourth quarter.

Chris Horvers – JP Morgan

Is there any indication now in the business on the NAD side that maybe people are looking to fulfill the corporate budget for the year, where as maybe a year ago they were really looking to not spend it all and didn’t even fulfill what they had originally planned?

Joe Doody

At the beginning of the year we have new budgets issued for many and that’s why we see a good spike in our January business, our back to business time period. You don’t find a lot, you’ll find a lot of times at this time of year they’ve used their money up or they’ll put a freeze on spending and that’s not going to be new this year, that’s happened over the last several years. We’re comping over that same factor and we do expect as the new year begins that there will be that pick up and we’re hopeful that it will be back to levels of a year or two ago versus last year.

Operator

Your next question comes from Gary Balter – Credit Suisse

Gary Balter – Credit Suisse

You mentioned, the question was asked but I didn’t hear the answer, you mentioned that rent was a negative with flat comps. What comps do we need to get positive leverage on rent?

John Mahoney

The big thing on rent is that over the last couple years the mix of stores has been high rent market so our rent has gone up, that’s the biggest factor. I think with flat comps and a slight increase you’re going to see slight de-leverage. I don’t think we would target a particular comp for that, it depends as much on the mix of stores for next year which we don’t have yet as anything else.

Gary Balter – Credit Suisse

As you look at technology that was clearly a driver and was a driver Black Friday sales for you and it was very well done based on the lines at your stores. Do you worry that that’s fleeting, that the customer buying the technology product isn’t going to be a customer? How important is Easy Tech in keeping that customer and making them a full time Staples customer?

Demos Parneros

Yes, we were because that is a deal seeker on that day. Clearly people are up at two in the morning getting in line they want to basically cherry pick the deals for what they want. Obviously we do our best to sell not only the base hardware product the computer in this case but the associated basket with it. We actually, I think, did a pretty good job with that. By taking a few extra minutes and walking customers through what they need whether it be antivirus or some of the other basics that they need, software.

Parts of Easy Tech is high for us and the growth that we’re experiencing in Easy Tech has been encouraging. We’ve continued to work hard in this area, we’ve invested particularly in people, in store presence, a lot of the offers and promotions that we’ve had out there so the good news there is a lot of customers have tried this service over the past year. We’re seeing continued acceleration so as we continue to get customers into the stores they sample the type of service that we’re offering, they gain trust and I think we can hold onto those customers for their future needs.

Gary Balter – Credit Suisse

If you look at 2010, I know you’re not giving guidance at this point but Retail we could kind of model because you don’t really have a Corporate Express impact in there but you do have some synergies. How do you start thinking about what could happen North American Delivery just as a first quarter comparative and it was up 10 basis points. How do we think about International, how do we model a clean year where you’re still getting some synergies but they’re going against the complete Corporate Express ownership?

John Mahoney

As we’ve talk we’ve got two big conflicting factors in there. We’ve got the revenue declines and a less attractive product mix which has hurt us. We’ve got the synergies which have been a big help. We’re very proud of the job that Joe and Steve Bussberg and his whole team have done in terms of managing expenses so that they maintain an operating margin equal to last year in the face of relatively significant declines.

All that means that a lot of the inefficiencies and duplications are getting identified more quickly and as we can get some revenue growth I think you should expect to see that operating margin improve. Even in an environment where we even get back to something like zero, that operating margin rate should go up. I think you have to predict the rate at which revenue improves, something that we’re not ready to do yet in order to be able to model it effectively. I think that’s why you get paid the big bucks.

Ron Sargent

It is a little difficult because we’ve got a lot of moving parts. I think there are probably some things that are going on in our business that will probably be depressing on margins. I think once we get back to more normalized environment, International will grow probably faster then North America which has a depressing effect on margins. I think the technology mix as the business evolves has a negative effect on margin.

The positives though, I think own brand is continuing to grow as part of the mix and that’s a good news story on margin and I think services will continue to grow as part of the mix and that’s also good news. I think again, in a more normalized environment, not right now, Delivery I think will probably grow faster then Retail. You’ve got three ups and you’ve got two downs and I think our job is to manage that in a way that its a nice progression up.

Gary Balter – Credit Suisse

We’ve been doing a bunch of channel checks and consistently people have been saying that you’ve lost some contracts on price to some of your competitors and yet that’s not what we heard today. Kind of attach those too because basically what you said is your business you didn’t lose contracts, you actually gained. The ones on-contract that the business went down. Where is that inconsistency?

Joe Doody

As you know, the market share in terms of our overall business looks good. If you look at our one year, especially our two year comps. When you talk about what we do as far as our go to market program its a lowest cost to serve model and it resonates very well with our customers. There are some customers, especially some that are former CE customers that it doesn’t and they won’t change their behaviors. Selectively we have given ultimatums to those customers to change their behaviors or we in fact walk away. There have been some of those. In some cases some of those have gone to our competitors. That doesn’t worry us.

Ron Sargent

The numbers are the numbers.

Operator

Your next question comes from Brian Nagel – Oppenheimer

Brian Nagel – Oppenheimer

As we look at the Retail side of the business is there any way to quantify what impact the increased incentive compensation had upon Q3 margins say versus Q2?

John Mahoney

It isn’t something that we disclose. I would say that as we talk about the various factors that impact margin we try and highlight only those that have somewhat material effect. We did include it as one of those factors but its also one of several others. I would say that you know about what incentive compensation represents and so I would assume that there’s been small or no accrual last year and we’ve accrued based on decent performance this year.

Brian Nagel – Oppenheimer

We talked about in the past, if you look at this Staples business through prior cyclical downturns how Retail tends to rebound first and then followed by the Contract businesses. As we continue to slog through this economic downturn have you seen anything to suggest that trend would be different this time?

Ron Sargent

I’ve seen nothing that would indicate that this recession is wildly different then other recessions that we’ve experienced in the past.

Operator

Your next question comes from Matthew Fassler – Goldman Sachs

Matthew Fassler – Goldman Sachs

If you could first of all just shed a little more light on the change in the Europe comp from the second quarter when in local currency I believe it was down 3% and it took a bit of a step back in Q3. I know you talked about which markets were better and worse but where did you see the deceleration?

Mike Miles

We’re really seeing softness in the office center businesses in Europe which are a more technology heavy business then the Staples branded stores we have in the UK and Germany. Although we’re soft and more negative then all the retail markets in Europe it was really those two businesses that drove the steep -9% decline that we had. Although its distressing top line number, because it is technology that’s been soft, the impact on the bottom line has not been as pronounced and the margins are for Europe Retail overall has held up pretty well.

Matthew Fassler – Goldman Sachs

Given that European macros are getting a bit better it sounds like I’m not that familiar off hand with what’s happening in the Netherlands per se, is that a regional issue or a franchise issue that you have there, if so, is there a solution on the table for it?

Mike Miles

Its probably more of a store specific issue. The recovery across Europe is, if you can call it a recovery, is pretty checkered. We’re still looking at negative GDP growth in the UK and in Spain, France is still pretty weak. I think the issues though that we have with the office center brand over there are more specific to the chain then they are driven totally by the economy. Although obviously the soft economy is what is contributing to the down draft on the technology business because those are the purchases that around the world we’re seeing deferred in this kind of a cycle.

Matthew Fassler – Goldman Sachs

Related to the miscellaneous income line which I think had roughly an $11 million year on year swing. In the Q you attributed it to currency gains. If you could remind us what tends to show up in that line and how should we work to forecast it?

John Mahoney

The biggest issue there is really Canada where we generate a lot of cash and we try and do some borrowing activity to offset the cash we’re trying to repatriate. Its really the currency swing between the Canadian dollar and the US dollar, we bring cash into the US.

Matthew Fassler – Goldman Sachs

Higher level on capital allocation, you articulated your priorities for deployment of cash flow. You net debt is way down, your cash balances are up nicely. While you spoke to limited working capital improvements going forward your cash flow from operations should still be quite strong. At what point do you anticipate being ready to contemplate buying back stock?

John Mahoney

We have a fairly cyclical first half of the year so I think as we start getting towards the middle of next year and we see how next year is going from a cash flow perspective I think we would want to be deciding what to do with our capital structure around that timeframe.

Matthew Fassler – Goldman Sachs

If you were to look today at your alternative, since you’ve paid down I guess most of the debt that you can right now, virtually all your short term debt. Is share repurchase or debt repurchase more attractive from a financial perspective?

John Mahoney

Right now the debt repurchase looks like its very, very expensive given the performance of our bonds. When you think about cost of capital you would think that share repurchase would probably be more attractive as you sit here today. As we get into the middle of next year we’ll have to take a look at what interest rate predictions are out there and make a decision based on the climate at the time.

One of the things that we did do when we issued our bonds is we tried to make them very short term so that we’d be able to pay them off fairly quickly in the worst case so we do have those two year bonds that come up in ’11 and then the 9 ¾ are only five year bonds. I don’t feel any great urgency to buy back those bonds at unattractive economic terms.

Operator

Your next question comes from Stephen Chick - FBR

Stephen Chick - FBR

I wanted to ask some questions around the North American Delivery trends, you mentioned that North American Retail comps I think you said improved steadily through the quarter. I was wondering if you could speak to how the sales trends were within NAD through the quarter and if you had the local currency figure I think you gave the total reported decline, if you had the local currency handy.

Joe Doody

I don’t think we had any currency impact in the quarter, not material in the quarter. What you saw there is what it is.

John Mahoney

The only impact of currency in NAD is the relatively small Canadian business and it was not material this quarter.

Stephen Chick - FBR

Could you speak to how the quarter, the down 11% would you mind speaking to how the quarter progressed for that number and maybe giving us a sense of how the quarter ended?

Joe Doody

We’re still bumping along the bottom, to be honest with you. I don’t feel that we’re seeing any strong trend one way or the other. We certainly have seen a trend upward in our small business customers and we noted that with SBD which is Staples Business Delivery. For our Contract business for the most part is still bumping along where we hope is clearly the bottom and looking for movement upward as we now start comping over obviously much easier numbers in the later part of this year and the beginning of next year.

Stephen Chick - FBR

I think last quarter you spoke to Quill and SBD I think combined if I had it right. Can you speak to those sequential improvement this quarter versus last? It sounds like Quill was the same if I had that right.

Joe Doody

Quill was the same, Staples Business Delivery sequentially improved and Contract was slightly better.

Stephen Chick - FBR

I know you don’t want to get into more so much detail around your sales expectations for the fourth quarter in your guidance. There’s a lot of moving parts for us trying to make some assumptions and we can use two and three year stack trends and things like that. The North American Delivery comp comparison so to speak is very, very easy in the fourth quarter. I know January is the biggest month. Can you give us a sense of what you guys directionally expect for that business I guess, speaking to it amongst the three; the Quill, SBD and the Contract?

John Mahoney

I think you’re right, there are a lot of moving parts. Obviously the two year comp trend is important and as you can hear from our aggregate guidance we’re feeling like the business overall will grow in US dollars. I think you’ll have to decide what you think is the impact to the economy as you make your NAD plans. We’ve told you the trends in the business that SBD has seen some improvement and that we haven’t seen improvement in either Quill or in the Contract business, slight improvement in Contract.

Depending upon what your assumptions are about employment and a number of the other factors that impact our business I’d consider those along with the two year trend as you plan what you want to put in your model.

Joe Doody

We feel real good about our customer acquisition activity and it really comes down to purchases from existing customers.

Stephen Chick - FBR

The goodwill account it looks like went up sequentially if I have it right. Is purchase accounting, is that kind of finalized now?

John Mahoney

It is. It was finalized last quarter.

Stephen Chick - FBR

The increase in goodwill what was that related to?

John Mahoney

That was just a re-class.

Operator

Your next question comes from Colin McGranahan – Sanford Bernstein

Colin McGranahan – Sanford Bernstein

The inventory performance continues to be quite strong, down 11% was certainly better then we’d expected. I think you said NAR inventories were down about 8% on a per store basis. If my donkey math is right that means that the rest of the business might have been down like 14% or so. Can you help me understand what’s driving that? Is that consolidation of private label products, its a very strong performance I just want to understand what the drivers of that are?

John Mahoney

I don’t think its any one particular factor. As we’ve gotten farther down the road on integration of the Corporate Express business I think we’ve been able to deploy inventory where we need it most effectively. We talked about sharing operating practices between Corporate Express team and the Staples team and I think as operating practices in our fulfillment centers have improved we’ve been able to plan better where to have the inventory that we need.

Joe Doody

The only think I’d add is better working with our vendors and a reduction of safety stock as a result of that.

Colin McGranahan – Sanford Bernstein

I think your quote was you intend to take a big step in profitability in Europe in 2010. Clearly it sounds like the Printing Systems losses should be smaller given some of the right sizing, maybe China losses get a little big smaller. What are other drivers there and can you at all characterize how big a big step is?

Mike Miles

I’ll let John do most of the characterizing of the actual order of magnitude. I think what I said was significant step. I can tell you that I think we’ll benefit next year from the European buying effort that has been underway and is yielding some nice savings as it did in North America. As I mentioned, we’ve had good discussions with the Works Councils in Europe that have allowed us to right size the businesses that are operating in the same country there as a result of the acquisition of CE.

We’re doing some consolidation on the supply chain side in Europe as well and that’s going to yield some significant improvement. Good indirect buying negotiations is going to have some upside and we’ve cut G&A in the headquarters in Amsterdam. There’s a lot of things that we’ve had in the works and have been talking about through 2009 that should begin to pay off in a way that you can see in 2010.

Operator

Your next question comes from Anthony Chukumba – FTN Equity Capital

Anthony Chukumba – FTN Equity Capital

You mentioned that you increased the average order size for Corporate Express from $160 to $180 and you contrasted that with Staples average order size which is $225 and correct me if any of these numbers are incorrect. My question was, is the goal to get the Corporate Express average order size from the $180 to the $225, if so what would you project the timing of that being? If you could give us any idea about what positive impact that would have on your margins in NA Delivery?

Joe Doody

Your numbers are pretty close to accurate there. Yes, our goal is to drive it up. I would say that its unrealistic to expect we’ll get all the way there. The makeup of the customer base is a little bit different but we should get continued substantial improvements in that area. We’ve not really quantified what the impact to our margin is from that but clearly it does a lot in terms of allowing us to build larger orders for our customers to increase our efficiencies within our fulfillment and especially our Delivery operations. That’s why we’ve had such a successful model in our Contract business to date in Staples that we’re bringing some of those best practices to our CE customer base.

Operator

Your next question comes from Joe Feldman – Telsey Advisory Group

Joe Feldman – Telsey Advisory Group

A follow up on some of the business customer trends. Are you seeing any encouraging signs or anything right now that gives you some encouragement that as we get into next year that I don’t know either hiring is going to start picking up a little bit or that at least you’ll see your sales trends start picking up among small and medium sized business customers even from the sequential improvement we’re already seeing?

Ron Sargent

We look at a lot of different data just like you guys do. We look at what’s going on with GDP, we look at white collar job growth, we look at consumer confidence, CEO confidence and small business optimism. I think the trends are getting better and I’m certainly not an economist but if somebody asked me is the recession over, I would say the recession is over and that recovery has begun. I’d also say that the county’s number one priority should be getting people back to work. I think jobs and credit so that people can hire is probably high on the list of improving the economy.

I think as it relates to Staples, we are seeing nice recovery in our stores, we’re starting to see the pick up in our catalog business. Not as much in Contract and I think if people aren’t working they’re not consuming office supplies. Our efforts have really been to focus on things we can control like getting this integration behind us, providing great customer service, great assortment. I think there’s cause to be optimistic about the direction of the economy. It all hinges to me on job growth.

Joe Feldman – Telsey Advisory Group

I think in your prepared remarks you’d mentioned that the 25 countries that you’re in there are many that are more profitable then North America, there are some that are not profitable at all. My question is really are you considering retrenching in any areas, not that I expect you to name countries but would it get to a point that you would actually step back from anywhere and what would drive that decision?

Mike Miles

We consider International to be a big growth vehicle for us so certainly the emphasis is not on retrenching. There’s nothing magic about it being 25 or 26 or 24 countries. If there are places where we don’t think we can make money in the near term that aren’t major strategic growth vehicles for us like China is, yes we’ll back away from it. I mentioned that we consolidated out of Hungary, we basically stopped operating a business in Hungary and are serving it from Austria. We’re looking at other countries around the world through the same lens.

Operator

Your next question comes from Alan Rifkin – Bank of America

Alan Rifkin – Bank of America

With respect to the Corporate Express integration you’re still sighting the same $300 million that you sighted 15 or 16 months ago, yet a lot has happened between then and now. Can you maybe just provide a little bit of color, within the integration what things have gone better then your original expectations, what things have lagged, and how much of the $300 million has been realized in 2009 as we’re essentially at the end of the year?

Ron Sargent

From my perspective the whole thing has been a little surprising about how well it has gone to date. Usually when you’re acquiring a big company there are things you don’t know about or surprises that come up along the way. I think we’ve done a lot of integrations over the past several years and we created a really crack integration team to guide us through this time as well.

Obviously the big money and the deal was paid for by getting the integration well down the path in North America and so that’s where we focused first. I think we’re right on track. With the new catalog, which has been an enormous amount of effort to get Staples brand and Corporate Express brand together and then having a catalog that we can issue to the entire customer base has been a lot of work. We’re spending a lot of time on systems projects to integrate systems and then the last and probably the slowest part of the integration will be on the distribution side.

The branding has gone extremely well I think across North America as well as Europe. I think the integration focus is now shifting away from North America because at some point it becomes operating your business and now it is focused on Europe. With the time associated with Works Councils agreements and as well as the potential that’s why we did that second. I think Mike and the European team have done a nice job of starting with the vendor consolidation just like we did here.

We’ve done a lot of specking out in terms of systems and product and brand and again distribution. At some point, as John said earlier, integration becomes part of doing business. We said that we would have a three year process, I think we’re certainly on track to get it done in three years. In terms of the $300 million I think we pegged $120 million the first year, $120 million the second year, and that leaves $60 million for the third year. I think we’ve going to be right on track with that. Is there some upside along the way? I’ll know in another 18 months whether there was upside to the $300 million number.

John Mahoney

One of the hallmarks of successful integrations in the Contract business has been to be very attentive to things that impact our customers. With the number of customers and the number of sales associates from Corporate Express that we’ve had to train and communicate with, my guess I would say that that maybe has gone a little slower then I would have hoped. I think the upside from that is that its resulted in very good retention of our existing customers. Getting through that will have an impact on our ability to get the profitability of all the accounts in the portfolio up to where Staples accounts are.

If you look back at Quill acquisition or National Office Supply or even some of the smaller ones we’ve done recently, I think the key has been that we make sure that customers feel like they get value out of the deal as well. Making sure that happens with the CE customers is very important to us and means working hard at that.

Alan Rifkin – Bank of America

Given your past comments with respect to the economy, and it certainly sounds like you’re a lot more optimistic then you were even three months ago. Would there be any reason to believe that the progression or the time or even the slope of the curve with respect to the Delivery business and SBD, Quill and Contract how they come out of the recession. Should this emergence be any different then past cycles that we’ve seen?

Ron Sargent

You’re asking me a question that’s way beyond me at this point. I have no idea whether this is going to be a “V” shaped recovery or “U” shaped recovery. I certainly hope its not a “W” shaped recovery. I think this recession, at least in terms of our business, seems to be behaving like the last recession that we saw in 2001.

Operator

Your last question comes from Mitch Kaiser - Piper Jaffray

Mitch Kaiser - Piper Jaffray

Could you talk a little bit about small business performance? You saw some nice improvement but yesterday we saw the small business optimism index decline pretty substantially. Maybe what your small business customer’s are seeing and how we reconcile those two things.

Ron Sargent

Its hard to experience it in real time because GDP is not something that correlates with our business in the short term but it does over the long term. It does seem like in past recessions where large companies have laid off hundreds of thousands of workers like this time that a lot of those laid off workers either they’re setting up their home office, they’re starting the job search, they start their own companies, they become accidental entrepreneurs. I think typically large companies are the last to lay people off but they’re the last to bring people on as well.

I wouldn’t be surprised if a lot of these former large company folks are now spending some money and getting started whether its on the job search or starting their own business. What does that mean to the small business confidence index? Again, I think with small businesses in general people are concerned about credit and people are concerned about how long this thing is going to last. Back to my earlier comment, jobs is the answer and I think that should be the focus of our nations economic policy at this point.

Mitch Kaiser - Piper Jaffray

Your performance in small business has always been strong. Do you feel like you’re taking share then?

Ron Sargent

We monitor every product category. We also monitor the channels we operate in. I think the numbers would indicate that we seem to be taking share, that we’re growing faster then a lot of the businesses that we operate in. Having said that, I think we feel like we’ve been taking share throughout the entire recession and typically when recessions end that’s when you really get the pogo stick effect and maybe we’re starting to feel that a little bit now in the retail business.

Mitch Kaiser - Piper Jaffray

You mentioned Delivery expenses being a positive in the quarter. I know diesel prices on a year over year basis are starting to tick up a little bit. Could you quantify what it was in Q3 and maybe what we should expect on that line going forward?

John Mahoney

I don’t have the specific figure in Q3. I can tell you that in general $1.00 on the price of a gallon of diesel gas is worth about $7 million for us in a quarter.

Operator

I will now turn the call over to CEO, Ron Sargent for closing remarks.

Ron Sargent

Thanks for joining us on the call this morning. I realize we went a little late. We look forward to speaking to all of you again very soon.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. Everyone have a great day.

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Source: Staples, Inc. Q3 2009 (Qtr End 10/31/09) Earnings Call Transcript
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