OfficeMax Inc. Q4 2009 Earnings Call Transcript

Feb.17.10 | About: OfficeMax Incorporated (OMX)

OfficeMax Inc. (NYSE:OMX)

Q4 2009 Earnings Call

February 17, 2010 10:00 am ET

Executives

Sam Duncan - Chairman & Chief Executive Officer

Sam Martin - Chief Operating Officer

Bruce Besanko - Chief Financial Officer & Chief Administrative Officer

Tony Guiliano - Vice President & Treasurer

Analysts

David Strasser - Janney Montgomery

Bradley Thomas - Keybanc Capital Markets

Kate Mcshane - Citi Investment Research

Oliver Wintermantel - Morgan Stanley

Matthew Fassler - Goldman Sachs

Chris Horvers - JP Morgan

Gary Balter - Credit Suisse

Mitch Kaiser - Piper Jaffray

Operator

Good morning. My name is Ashley and I will be your conference operator today. At this time, I would like to welcome everyone to the OfficeMax fourth quarter 2009 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. (Operator Instructions)

I would now like to turn the conference over to Tony Guiliano, Vice President and Treasurer of OfficeMax. Sir, you may begin your conference.

Tony Guiliano

Good morning everyone and thanks for joining us today. I’m here with Sam Duncan, our Chairman and Chief Executive Officer; Sam Martin, our Chief Operating Officer; and Bruce Besanko, our Chief Financial Officer and Chief Administrative Officer. Before I turn the call over to Sam Duncan, I have a few administrative items.

Today’s conference call will be archived on our website for one year following the call. Certain statements made on this call and other written or oral statements made by or on behalf of the company constitute forward-looking statements, within the meaning of the federal securities laws. Management believes that these forward-looking statements are reasonable.

However, the company cannot guarantee that actual results will be consistent with the forward-looking statements, and you should not place undue reliance on them. These statements are based on current expectations and speak only as of the date they are made. The company undertakes no obligation to publicly update or revise any forward-looking statement whether as a result of future events, new information or otherwise.

Important factors regarding the company, which may cause results to differ from expectations, are included in the company’s Annual Report on Form 10-K for the year ended December 27, 2008 under Item 1A “Risk Factors”, and in the company’s other filings with the SEC.

It is now my pleasure to turn the call over to Sam Duncan, Chairman and CEO of OfficeMax.

Sam Duncan

Thanks Tony and good morning everyone. On today’s call, I’ll review our overall performance and Sam Martin, our Chief Operating Officer, will discuss our fourth quarter operating segment performance and current initiatives. Then Bruce Besanko, our Chief Financial Officer, will review financial details and our outlook for 2010.

As you likely saw last week, I have announced my plans to retire as Chairman and CEO of OfficeMax on February 28, 2011. My decision to retire is strictly personal. Our three daughters and our four grand children reside in Portland, Oregon. My wife and I have our main home in Portland, and after being away from our kids for seven years, I feel it’s time to return to the Pacific Northwest. Deciding on the February 2011 retirement date allows our Board the necessary time for a comprehensive search for my replacement. The Board will review both internal and external candidates.

I am proud of what we have accomplished during my tenure, as we have completed a turnaround of the company, built a great executive team, and positioned our business to execute a new growth plan over the next five years, and all of this has been achieved during a very difficult economic environment. Our focus now is on executing our new and ongoing initiatives, all of which are part of our five year plan that we will present in March.

With that said, let me begin with a review of our 2009 performance. I feel good about our business in the results our team delivered in the fourth quarter. I am pleased with our improving performance over the course of 2009 in a very tough economy. Notably in the fourth quarter, the year-over-year sales decrease moderated on a sequential basis, consistent with the trend we saw in each of the first three quarters, and we also expanded gross margin.

This is a positive turn for the business and was a particularly good improvement versus our plan for the quarter. We continued to streamline our business operations throughout the year in order to better position OfficeMax for profitable growth. I am also proud of what we accomplished with our liquidity and balance sheet as we are in much stronger financial position than last year.

Turning briefly to our results for the full year, total sales decreased 13% compared to 2008. Adjusted operating income was $63 million and adjusted net income was $19 million or $0.24 per diluted share. In the fourth quarter we exceeded our internal expectations and had a better than expected holiday season with total sales decreasing 4% compared to the prior year period, an adjusted operating loss of $2 million and an adjusted net loss of $2 million or $0.03 per diluted share.

We have been encouraged by recent reports that the economy has continued to modestly improve and that business spending is slowly picking up. In addition, it appears that unemployment levels are at least stabilizing, although at very high rates. We believe these economic trends were reflected in the better than expected holiday season for OfficeMax, as well as many other retailers.

That said, we believe that the recent economic turbulence has created a new norm in terms of consumer and business spending, and expect that customers will continue to be very budget conscious even as the economy strengthens.

Throughout 2009 we continued to make progress on our three key areas of focus: Growth, differentiation, and productivity. These focused areas significantly benefited performance in a challenging environment. To recap some of our progress through the year, we droved increased profit through our discipline growth strategy expanding the channels and categories through which we sell value-added products and services with minimal capital investment.

We are continuing to make good progress on our stores in the store initiative, which leverages our expertise in sourcing and merchandising of office products and school supplies. We completed our first full year with Safeway and are making progress with additional retailers for expansion.

Also in 2009, we enhanced the functionality of our e-commerce platform to make it easier for customers to shop our website. As you will hear from Sam in just a moment, we are very pleased that our site performed well during the heavy volume holiday season. Additionally, we made a commitment to compete by broadening our offering of services and products not on price.

As such, we are extremely focused and disciplined with our promotional activity during the year, including the holiday season. We also continued to focus on differentiation in order to stand out in the marketplace. We continue to offer an unmatched breadth of services including our integrated solutions offerings for large and middle market customers, our alliance with Lyreco to serve global business customers and domestic shipping services through our agreement with FedEx and our retail stores.

We have added unique products and services that we believe are core customers line compelling and have highlighted our value message in the marketplace. Let me take a moment to say Lyreco’s CEO, Eric Bigeard recently announced he will be retiring soon. Eric has done an outstanding job leading Lyreco, and we wish him well in his retirement. Finally, we have continued to focus on our productivity initiatives to maximize our resources.

During the year, we continued working to preserve our strong balance sheet and to manage our business more efficiently by conserving spending and by streamlining operations. As I’ve said in the past, while we have made great progress in enhancing our productivity over the last few years, we still have a long runway for improvement, even though these opportunities may be more challenging to achieve going forward.

Overall, I am extremely pleased with the progress that we have made in 2009, particularly in relation to our three key areas of focus. While 2009 proved to be a difficult year, I believe that we achieved sustainable benefits and competitive advantages that will endure well into the future.

I believe that with our improved operations and the economy turning the corner, we are ready to begin investing in the business again in order to facilitate growth. I remain confident that OfficeMax is in a good position, competitively, and what we know to be a very large and fragmented industry.

At this time, let me turn the call over to Sam Martin to discuss some specific details of our operations.

Sam Martin

Thanks Sam and good morning everyone. As Sam mentioned we remain focused on operating efficiently, reducing expenses and maintaining a strong financial position. However, we also continue to make progress on initiatives that differentiate us from the competition and position us for longer term growth. We ended the year more strongly positioned with our sales and margin trends improving as the year progressed.

Turning first to our contract business; sales in our U.S. contract business, which accounts for greater than two-thirds of our total contract segment, we’re down 5.8% in the third quarter and 14.9% for the full year compared to the same period last year. We continue to see further improvement in the trends of both new and existing business.

Declines in sales to existing customers continue to moderate during the fourth quarter; however, we continue to experience pressure from a product mix shift to lower margin categories, as well as customers purchasing on contract, and we don’t expect that this trend will end anytime soon. We are pleased that our successful customer acquisition efforts over the past several quarters were evident in our fourth quarter sales.

As revenue from new customers exceeded lost revenue from former customers for the first time in many quarters, we know our focus on differentiation is resonating in the marketplace, and we are winning business largely due to our integrated solutions offering that helps companies spend more efficiently on their office supplies, while giving us an opportunity to provide them with services that benefit them and reduce their spend in other related areas of their business.

During the fourth quarter, we adjusted the span of responsibility with our senior sales force level to better align the leadership of field sales. In addition, we expanded our director of business development program. This program is one of the most successful initiatives that we’ve rolled out over the last four years, and these directors have been driving a significant portion of the profitable growth in our new customer acquisition.

As we’ve discussed, 2009 was a testing year for our middle market task force. Throughout the year, we focus on consolidating aligning rolls to more effectively meet customer needs, better acquire and retain business and eliminate some cost redundancies in our business. We are very pleased with the results for the year as our tests have proven there is an opportunity to grow the middle market, and we are beginning to see positive results.

We will continue to focus our efforts on growing in the middle market and look forward to seeing additional benefits as we move forward. Our officemax.com business has continued to show improvement in growth and as Sam Duncan mentioned, has proven to be one of the most reliable and productive websites in our space, especially during the critical Black Friday and Cyber Monday periods.

We have been driving more traffic to our sites since the March 2009 re-launch with more aggressive online marketing and coordination with offline marketing. Notably, our new site design and the enhanced usability of their home page, as well as category pages for the holiday season improved the officemax.com shopping experience in the fourth quarter. We further enhanced the site by adding features such as video product reviews.

Now for an update on our International contract business; in the fourth quarter of 2009, International contract sales increased 13%, but declined 7% in local currencies from the prior year period due to continued impact of the weak global economy, which was more than offset by the continued weakness of the US dollar compared to the prior period.

In the fourth quarter, we completed the first full year of our three year agreement with Lyreco and continue to be pleased with our positive momentum and waiting global business. We look forward to furthering our relationship and strengthening our combined offering, as together Lyreco and OfficeMax provided excellent solution to address the global needs of our customers.

Overall, our contract performance in the fourth quarter reflects our disciplined approach to profitable customer acquisition and tension, as well as other initiatives to grow the business and improve margin by providing better solutions for our customers. We expect that with our realigned sales force in the right service and product offerings we will continue to gain traction.

Turning to our retail business, same-store sales for the quarter declined 6.7% compared to the prior year period. Store traffic and transaction size were slightly lower for the quarter due to a weaker environment than last year. However, we had a better than expected holiday season and I’m happy to say we executed our holiday plan well.

We are also pleased to see favorable results from our new partnership with FedEx, which are exceeding our expectation. All three major product categories continue to comp lower for the quarter. Our technology category which includes Ink and Toner comes down low single digits, helped by strong growth in control center, and our 24/7 PC tech support offering.

As we discussed on last quarter’s call, the launch of Microsoft Windows 7 is a driver of software and PC business during the fourth quarter. We were pleased with our execution in the technology category during the holiday season, as we remain focused on margin and were prudent in our promotional activity.

Overall, we focused on offering a great value and providing a gifting solution for our core customer and we achieved better than expected results for the season. We’re pleased with our improvement in retail gross margin in the fourth quarter compared to the prior year period, which was helped by good improvement in shrinkage due to our improved internal control.

Our occupancy expense delevered in retail, but was still lower as a result of the cost reduction efforts we made in partnerships with our landlord. Also our continued disciplined approach to pricing and promotional activity helped us to maintain product margin.

We’ve exited the holiday season in good shape for our Back to Basics program, which is a very important first five weeks of the year as businesses restocks supply. While business trends remain challenging, our team executed well and we were pleased with our results during the Back to Basics period.

On the marketing front, we have done a good job of bringing down our print media spend in order to free marketing dollars for more effective campaign. ElfYourself.com the most popular viral experience in web history returns for the fourth year. In January, we launched the ‘Work with us’ media campaign, our largest in more than five years and are very pleased with the feedback thus far. We believe that the shift in focus from print to television and targeted internet advertising will drive brand awareness in a higher ROI on marketing spend.

With respect to our real estate, at the end of the fourth quarter we had 1,010 stores. We opened 12 new stores and closed 24 stores for the full year in the U.S. and Mexico. While we don’t see the need to close a significant number of stores in the near future, our lease terms provide us with flexibility over the next several years to close or relocate stores if necessary. While we will continue to look for opportunistic expansion opportunities, we have only two plans for our openings in 2010, both of which are in Mexico.

Proprietary products continue to be a growth area for us, both contract and retail, and remain a key way that we are differentiating OfficeMax from our competition. In 2009 we continued our strong growth and achieved an overall sales penetration rate of approximately 29% for the product categories in which we have proprietary products. This rate was almost about five points higher than the prior year and almost double the rate from four years ago.

We recently rolled out new furniture options that offer the design and product quality our customers desire at compelling price points. Overall, our private brands meet the needs of our core customer interests in trend right products, while providing a good value. Importantly, we’ve been able to improve our productivity by making progress in controllable costs due to the collaboration of our operators, supply chain and our merchants.

As a result of these and other initiatives, we’ve reduced our annual fixed costs expenses over the last four years by more than $400 million. While we’ve made significant progress in the area, we still believe we have runway left to further improve.

Our inventory management initiatives have been extremely effective, and I’m proud to say that we exited the fourth quarter with very clean inventory. Clearance inventory levels were the best in company history, while in-stocks were a record high as well. Inventory per store was approximately 17% lower and inventory per distribution center was approximately 15% lower compared to the prior year period. In addition, we are driving fewer miles due to the better productivity.

The improvements that we’ve made have truly benefited the business as evidenced by our better than expensed fourth quarter results. I believe that we have proven through 2009 that OfficeMax is well positioned to grow with discipline to differentiate our business in the marketplace and to enhance productivity while improving the shopping experience, and we are excited about our prospects for 2010.

At this point I’d like to turn the call over to Bruce Besanko to review our financial results.

Bruce Besanko

Thanks Sam. Good morning everyone. Let’s begin by reviewing income statement highlights.

For the fourth quarter 2009, we recorded a net loss of $3.2 million or $0.04 per diluted share. Net loss for the full year was $2.2 million or $0.03 per diluted share. Excluding certain items that are non-indicative of our ongoing core business, adjusted net loss in the fourth quarter 2009 was $2.3 million or $0.03 per diluted share, and adjusted net income for the full year was $18.6 million or $0.24 per diluted share.

Adjusted operating income, adjusted net income, and adjusted earnings per share are non-GAAP financial, which we reconcile to GAAP financials in our press release. Details of these adjustments can be found in our press release that we issued this morning.

Focusing on the fourth quarter, consolidated net sales were better than expected and decreased by 3.9% to $1.8 billion. Excluding the impact of foreign exchange, consolidated net sales decreased 6.2%, which was a five percentage point improvement from our third quarter year-over-year decrease.

Fourth quarter contract segment sales decreased by 0.6% to $948 million compared to the fourth quarter of 2008 reflecting a 5.8% sales decline in U.S. contract and a 13.2% sales increase from international sales contract operation. In local currency, international contract sales decreased 7.3% and total contract sales declined 6.2%.

Fourth quarter retail segment sales decreased by 7.2% to $863 million compared to the fourth quarter of 2008 with a 6.7% decline in same store sales, and sales trends showed sequential improvement in most regions for the U.S. and Mexico.

OfficeMax gross margin expanded 20 basis points for the fourth quarter compared to the prior year and improved 70 basis points from the prior quarter. We’re pleased to see the positive trends after too many quarters of decline. For the fourth quarter, contract segment expanded 20 basis points due to stronger international margins.

Delivery costs embedded in margin continue to improve. Partially offsetting the gross margin was a continuation of the buying behavior we saw all year as customers continue to purchase a higher percentage of on-contract items than in the prior year, including lower margin commodities and consumables like paper.

Additionally, higher amortization expense, customer acquisition and retention payments deleverage the margin rate as overall sales decline versus the prior year period. Retail segment gross margin expanded 30 basis points for the fourth quarter, primarily due to lower shrinkage expense due to improved internal controls, which was mostly offset by deleveraging of fixed occupancy costs of lower sales.

We maintain product margin due to a disciplined approach to promotional spend. While we’re pleased with the modest year-over-year improvement in consolidated gross margin in the quarter which was better than our internal plan, we continue to have significant opportunity for expansion.

Total adjusted operating expense, which includes general and administrative expenses was 24.5% of sales in the fourth quarter 2009 as compared to 23.4% in the prior year quarter. Contract segment operating expense was 20.3% of sales for the quarter, up from 19.3% in the fourth quarter of 2008.

Retail segment operating expense was 28.1% of sales for the quarter, up from 27.0% in the fourth quarter of 2008. Overall operating expenses were impacted by $41 million of higher incentive compensation expense for the quarter and $55 million higher for the year compared to the same period of 2008, when we had minimal one set of compensation expense.

So in Q4, incentive compensation expense had more than a two percentage point impact to overall operating margin. As we described in the third quarter, our 2009 incentive compensation program requires significant EBIT achievement to trigger a payout. As a result, the cost of incentive compensation will accrued primarily in the second half of 2009 as it became clear that the program target would be met.

For 2010 we expect the incentive compensation accrual to be spread more evenly throughout the year. Our adjusted operating loss was $2 million in the fourth quarter of 2009, compared to adjusted operating income of $15 million in the prior year period.

This reflects a fourth quarter of 2009 adjusted operating income margin year-over-year decline of 80 basis points to 1.5% of the contract margin and the decline of 80 basis points to negative 0.8% in the retail segment. Corporate and other segment operating expense was $9.2 million in the fourth quarter of 2009 compared to $7.6 million in the prior year period due to higher pension expense and incentive compensation expense.

Now, let’s turn to the balance sheet. We’re very pleased with the success that we’ve had in strengthening our balance sheet in 2009 particularly in light of the difficult economic environment. At the end of 2009 we had cash and cash equivalents of $487 million and total debt, excluding the non-recourse timber securitization notes of $297 million, total borrowing availability as of the end of our U.S. and Canadian revolving credit facilities was approximately $513 million.

When combined with our $487 million of cash and cash equivalents, total liquidity at the end of the quarter was $1 billion. For those of you that are new to our story, I’d like to highlight that the total debt I mentioned excludes the $1.47 billion of non-recourse debt shown on our GAAP balance sheet.

As we’ve said in the past, in order to reflect OfficeMax’s obligations accurately, our companies along with third parties such as the two major credit rating agencies, exclude the $1.47 billion of timber notes from the calculation of various financial metrics and ratios used to assess the valuation or financial help of the company because they’re not recourse to OfficeMax. We have a list of answers to frequently asked questions regarding the non-recourse timber notes securitization program available on our Investor Relations website.

Now turning to working capital, due to the ongoing progress we’re making with our productivity initiatives, we again improved inventory turns in Q4 and we ended 2009 with inventory $144 million lower than at the end of 2008. Accounts payable at the end of 2009 was $68 million lower than the prior year period, primarily reflecting lower inventory levels. Receivables at the end of the fourth quarter were $27 million lower than the prior year, reflecting both volume declines and the contract segment and modest improvement day sales outstanding.

Turning to our frozen pension plans as of December 26, 2009. The pension plan was under funded by $210 million, which is less than one half the short falls as of the end of 2008. In the fourth quarter, we made a voluntary excess contribution of approximately 8.3 million shares of OfficeMax common stocks retention plans. This action had minimal impact on earnings per share in 2009, and we expect it to be accretive to EPS in 2010.

Now looking at cash flow for 2009, we generated $359 million of cash from operations in the challenging environment. In 2009, OfficeMax received $71 million of federal and state tax refunds, net of payments resulting from overpayment of estimated taxes and various other items. We also received $46 million from borrowings on accumulated earnings held in company-owned life insurance policies under GAAP which are under GAAP or accounted for in cash from operation.

Capital expenditures totaled $14 million for the fourth quarter 2009 and $38 million for the full year inline with our most recent estimate. This is the significant reduction from prior years as we have fewer store openings and more discretionary projects that were cut or postponed.

Now turning to our outlook for 2010, we expect to continue facing challenging macroeconomic conditions such as U.S. unemployment trends and over the near term with these trends beginning to work in the company’s favor toward the latter part of the year.

Additionally, the company plans to invest in initiatives to drive growth, and we expect a successful execution of the initiatives to benefit operations and financial results as the year progresses. Based on these assumptions we anticipate that for the full year 2010, total sales including the impact of foreign currency translations and adjusted operating income margin will be slightly higher than they were in 2009.

Please note that our outlook also includes the following assumptions for the full year 2010; first pension expense of approximately $7 million and cash contributions to the frozen pension plans of approximately $4 million, capital expenditures approximately $90 million to $110 million, primarily related to technology and infrastructure investments and upgrades, depreciation and amortization of approximately $105 million to $115 million, interest expense of approximately $74 million to $78 million and interest income of approximately $41 million to $43 million.

We expect the effective tax rate to be slightly less for this company’s marginal tax rate of approximately 39% with the caveat that the rate is very difficult to forecast with the high degree of precision due to the domestic and international sales mix at lower profitability levels.

We expect positive cash flow from operations to go lower than for 2009 due to the projected 2009 incentive compensation payout which will occur in the first quarter as well as from higher inventory levels. Our liquidity position will remain very strong and finally net reduction in retail store count for the year will occur with two planned openings in Mexico and up to 20 store closings in the U.S. and Mexico.

Looking at the first quarter, the January 2010 total sales percentage decrease continued to moderate compared to the year-over-year fourth quarter of 2009 total sales percentage decrease. We expect the sales trend for the first quarter of 2010, including the impact of foreign currency translation will be inline with what we saw in January.

We also anticipated adjusted operating income margin for the first quarter of 2010 will be inline with the prior year period. Overall, we’re excited about the prospect for OfficeMax and believe we’re taking the right actions to position the company to achieve a higher return on investment capital.

Now I’ll turn the call back to Sam Duncan.

Sam Duncan

Thanks Bruce. We feel very good about the positive changes that we’ve recently made to the business and expect that we will continue to contribute to our results in 2010. We have a great team in places who have worked extremely hard to streamline and right size our organization and put us in a position to leverage these improvements going forward.

As we mentioned before, we are encouraged by recent trends of stabilization in the U.S. economy. We acknowledge that the company will continue to face some headwinds such as U.S. unemployment trends over the near term and that the road to recovery is not likely to be smooth. However, we believe the macro trends we have been experiencing should be the tailwind for our business towards the latter part of the year.

Our recent survey found that consumers are hopeful for better days in the new decade and OfficeMax has positioned itself as a key partner for businesses to facilitate positive change. Building off this enthusiasm, our new work with this television advertising campaign which Sam Martin mentioned earlier demonstrates our dedicated support for businesses to do their best work.

We are optimistic regarding our future and plan to discuss our five year plan at our upcoming Investor Day. We are pursuing business opportunities that have the potential for meaningful growth and importantly these opportunities are where we already demonstrated competency. We believe our key initiatives, which include integrated solutions and contract in store within the store and retail are well aligned with our longer term directive of solid organic growth with a higher return on investment.

Finally, I want to briefly mention a few recent industry recognitions that OfficeMax has received. We were recently recognized as an outstanding distributor and an ability one top seller by the committee for purchase from people who are blind or severely disabled and independent federal agency that administers the ability one program.

We also received service quality measurement group’s procedures highest customer satisfaction for the call center award for the retail industry, scoring the highest ever of any company. Additionally, we were named the 2009 supplier of the year by the North American Steel Alliance for outstanding customer service and support and finally, we are honored to be the recipient of the 2009 CEO diversity leadership award presented by diversity best practices, the preeminent organization of promoting diversity in the work place.

Now let’s open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from David Strasser - Janney Montgomery.

David Strasser - Janney Montgomery

It seems like you have a lot more comfort in the business. The balance sheet’s looking very strong. You haven’t done much in the way of buybacks. Any thoughts about that as you look at 2010 or beyond?

Sam Duncan

That’s strictly a Board decision, and we haven’t made any decisions like that at this point. Not saying it might not come up in the future, but that’s certainly a Board decision that would be taken up at the appropriate time.

Bruce Besanko

Just to add David, right now we’re comfortable given the economic environment to hold the cash that we do have.

David Strasser - Janney Montgomery

I guess it just does seem like you do see more confident, put aside the buyback for a second, but you do feel like its more confidence and you seem to have more confidence in the business and maybe in the environment than you seemed to have had throughout a good part of 2009. Is that a fair assessment of your comments?

Sam Duncan

Absolutely, 2009 was very tough for everyone. I feel incredibly good about what our company has accomplished. Our people have done a fabulous job in all aspects, the operation, contract, retail or liquidity is outstanding. Absolutely I feel good about what we’ve achieved in the company.

Operator

Your next question comes from Bradley Thomas - Keybanc Capital Markets.

Bradley Thomas - Keybanc Capital Markets

I wanted to follow-up on the incentive compensation in the quarter. Bruce, I was hoping you could walk us through what that P&L impact would have been for the different segments and how much we should think of as catch up versus what would have normally occurred in the fourth quarter?

Bruce Besanko

Sure Brad. I want to start with just a little bit of background about what that incentive compensation expense is, and then I’ll go specifically to the question. I’m not prepared to go into what amount was in contract and what amount was in retail. I can give you a little bit more color on a consolidated basis.

As background, the incentive programs that were described in our 2009 proxy applies to all of the eligible employees in corporate field and store management. It’s not a retention program, rather it’s an annual incentive program. We had a significant amount of uncertainty, really principally the result of the macro economic environment.

At the time that the program was created in early 2009, that uncertainty led us to structure a program that required a very challenging EBIT target and for that EBIT target to be met, it would be a very challenging one and obviously we would have to beat that. So with the first half of the year, we didn’t have much of an accrual associated, because frankly we didn’t have a level of certainty around achieving that target, but by the third quarter we began feeling better about beating that target. So we began an accrual process that accelerated into the fourth quarter.

So in total for the full year, the accrual or the incentive compensation was sort of in the $65 million range. Obviously now as we turn to 2010, given the plan that we’ve outlined, we would expect that that figure would be similar to the 2009 figure, but it would be pro ratably placed over each of the four quarters rather than weighted as it was in 2009 toward the back half.

Bradley Thomas - Keybanc Capital Markets

How does that $65 million compared to 2008 on a full year fourth quarter basis?

Bruce Besanko

It was a little higher than 2008, actually a lot higher.

Bradley Thomas - Keybanc Capital Markets

Then just Sam, congratulations on your upcoming retirement and nice results over the last several years with the company. As you all think about hiring a new CEO, could you talk a little bit more about what sort of process the Board is going to take? I understand you are about to outline a five year plan. How do you weigh bringing in someone who may have a different vision with all of the work that you put into figuring out what the next steps are for the company over the next five years?

Sam Duncan

First of all, on my retirement I’m deciding on the 2011 date, I wanted to make sure that I gave the board plenty of time to go through a very thorough process. I did not want to retire and give like a 30 day notice or something like that. I just thought that would be totally unfair and the Board has got plenty of time, and they’re very thankful that they have a one year timeframe to go through the search.

They will decide on a company first of all to do the search, and then they’ll go through an interview process where that search company will interview with the search committee and then the process will start. The whole process could take any length of time and again, that’s why I gave the one year notice. I put a lot of blood, sweat and tears into this company. The core values we’ve instilled in the company, I’m very proud of how the company has absorbed those.

I hope that somebody would come in and to just continue on with what we have done in this organization. I’ve done my job here in the five years of getting this company stabilized, of what used to be a sinking ship is now a ship that’s sailing along very nicely of which I feel very good about and hopefully, the person coming aboard will set sales for bigger and better things.

Operator

Your next question comes from Kate Mcshane - Citi Investment Research.

Kate Mcshane - Citi Investment Research

Aside from the store closures that you identified this morning, can you identify and/or quantify some of the cost cuts you potentially planned for in 2010?

Sam Martin

We’ll be going through our initiatives for the next five years and certainly more specifically for 2010 in our Investor Day Conference, but just to give a little bit of color around what we see. Over the course of 2008 and ‘09, and more importantly in ‘09, we did a lot of reorganization and took a lot of headcount reductions out.

We’re looking in the near term to look at more systemic productivity that we can gain by enhancing some of our systems and retiring some redundancies and continuing on our opportunities for productivity improvements, and those are the kinds of things that will produce cost reductions for the short term.

Kate Mcshane - Citi Investment Research

Then in terms of private label, can you tell us how private label comps during the quarter and what percentage of it is of sales now and what you expect it to be in 2010?

Sam Martin

Proprietary brand sales were penetrating total sales by about 29% at the end of 2009, but we do that annually. That’s about 400 basis points better than it was in 2008, and like I said earlier, about double what it was four years ago. The comps in our private label sales actually were positive for 2009.

Even in the challenging environment we were able to move sales dollars positive in private label products, and that’s really from the introduction of new lines that we’ve articulated over the past four quarters. Certainly we’re very proud of these new proprietary brands that continue to bring us great opportunities for growth and margin enhancement.

Operator

Your next question comes from Oliver Wintermantel - Morgan Stanley.

Oliver Wintermantel - Morgan Stanley

So while you mentioned that sales in the U.S. contract business improved from existing customers, it looks like customers continue to spend more on consumables than contract items that shared margins. Have you seen any signs that the contract customers are going to spend more on discretionary items or off contract items in 2010?

Sam Martin

Our U.S. contract sales, customer spending has focused on the more, disposable kinds of products or dispensable like ink and paper, supplies, those core items. We don’t see, quite frankly, even with economic tailwinds, a lot of change in the way our customers behave.

That said, we do see an improvement in sales trends in our existing customers quarter-to-quarter, and more importantly our sale have been impacted by our ability to gain new customers at a faster rate than we’ve lost customers. The sales for the first time in eight quarters in the fourth quart this year were positive. We see that trend continuing in the first quarter of 2010.

Oliver Wintermantel - Morgan Stanley

Just one question for CapEx, I mean it’s going up to $90 million to $110 million. Can you give us a little bit more details of what you’re going to spend it on you mentioned tech, but maybe some more details there, please.

Bruce Besanko

The CapEx numbers of $90 million to $110 million really reflect a beginning investment in technology both at the corporate headquarters, but also places like our call centers out in the field. So there’ll be a heavy investment in technology.

Frankly, we think it’s an investment that is warranted and that will provide us the ability to really accelerate our growth or opportunity over the next several years. It’s heavily focused on technology investments. As you’ve heard from Sam Martin, there’s very little new store investment at this point.

Operator

Your next question comes from Matthew Fassler - Goldman Sachs.

Matthew Fassler - Goldman Sachs

First question I’d like to ask relates to retail. What’s your sense of what transpired with your retail market share during the December quarter? As you think about the financial goals that you’re setting for the retail business at this point, are you market share focused, gross profit dollar focused, how should we think about the way you’re gauging your success in that business?

Bruce Besanko

I think its important Matt, we haven’t really seen the analytics for market share for that recent period. Our sense is that, we’re going to measure our performance in retail in a growth way. We think we’re going to have a growth, we think we’re going to have some margin expansion.

Our initiatives are going to be targeted at both of those areas, and as we said we’re focused on growth differentiating ourselves from our competitors, and enhancing our ability to be more productive with our capital. So our turnover and inventory should be improving those sorts of things and we’ll gauge really our success with that, with our operating income in total weight.

Matthew Fassler - Goldman Sachs

Two quick follow-ups, you talked about the increase in CapEx for 2010. As we think about the long run capital needs of the business, would you consider 2010’s level to be more of a go-forward baseline, or 2009 to be more indicative of what you think you need to spend?

Bruce Besanko

I’d say that the levels that you saw in 2009 are more indicative of a maintenance capital program, and that as we begin to think about investment over the next several years that’s the 2010 number, at least in the shorter term that is to say the next one to two years is more than likely the number.

Sam Duncan

I hope 2009 is not our run rate, because that means the economy is very bad. We’re going to be somewhere in between 2009 and 2010, depending on what our needs are. We’ve made a lot of progress in IT and the company on supply chain and we’ll continue to make some investments, capital investments there that will continue on for a few years, but let’s hope that ‘09 is not the run rate.

Matthew Fassler - Goldman Sachs

Finally, share count, you had the issuance of stock for pension, which you indicated last quarter was coming. What is the appropriate diluted average share number that we should consider for our 2010 earnings estimates?

Sam Martin

It’s approximately $84 million, let me come back to you, Matt, but I believe it’s about $84 million.

Operator

Your next question comes from Chris Horvers - JP Morgan.

Chris Horvers - JP Morgan

I want to focus on the margins a little bit. First to go back to the incentive comp accrual, so the total for the year is $65 million, and that’s normally roughly equally spread out with that like$0.09 a quarter roughly…?

Bruce Besanko

Yes. It’s teens of millions of dollars a quarter.

Chris Horvers - JP Morgan

So then in the fourth quarter you had $41 million, which is call it rounded like $0.30, $0.32. Normally if you have like $0.09, $0.10 hitting, then $0.08, $0.09 hitting, then the distribution switch is next year.

So you have in the first half of the year, that normal kind of $0.09 impact for the fist two quarters, less in the third quarter because there was some catch up in 3Q and then this kind of $0.20 odd EPS tailwind coming in from a reversal holding equal? Not from a reversal, but normal incentive comp levels.

Bruce Besanko

What you said is essentially correct. That is to say we had such a heavy hit in the third and particularly in the fourth quarter. If in fact, we accrue ratably, which is what our plan is over the course of the four quarters there would be a headwind in the first quarter and second quarter and more of a tailwind in the back half.

Chris Horvers - JP Morgan

So maybe talk about SG&A dollar growth in 2010, excluding the timing of the incentive comp. How should we think about your potential SG&A dollar growth and then sales up modestly environment, maybe that’s 1%, 2%? How does the recent charges and restructuring that you take play into that versus the incremental spending?

Bruce Besanko

I would say the following. I would say the following. We have said all along that we’ve done a great job in terms of taking costs out. We’ll repeat what we’ve said in the past, but we’ve done a very good job over the course of the last several years. We’ve seen opportunities in the future that continue taking costs out.

Sam talked a little bit about that. It’s more structural in nature rather than sort of an effortless process, but we have that opportunity. As we make investments in the company, we would expect to see that kind of productivity occurs. We’ve talked that there’s a specific set of costs that has to come back into the company, and those are compensation related expenses.

So in early 2009, we suspended the 401k match as an example. We didn’t provide a merit increase for our employees over the course of 2009. So that kind of compensation expense needs to comeback and we’re making plans to put some of that back and perhaps even more of it as we see how the performance of the company occurs over 2010. So that piece of cost will comeback.

The other thing I would say is that we do intend over the course of 2010, and also into the five year process when we talk about that on March 4, that we do intend to reinvest back into the business. It’s not things we’ve taken out, but reinvestment both in CapEx, but also in G&A, and so that reinvestment will occur over the course of time. Again I want to emphasize, it’s not bringing back anything we’ve taken out, but rather an invest in generating dollars both on the top line and the bottom line.

Chris Horvers - JP Morgan

So then maybe another way to ask taken all that together, can you leverage SG&A over the year on a 2% type sales growth overall?

Bruce Besanko

My answer to that is probably not. If I look at 2010, I think that the expenses will be up relatively speaking because of both incentive comp and because of some of the compensation expense I talked about and then because some slight investment.

Chris Horvers - JP Morgan

Then one last one on gross margin, assuming that there’s no further degradation on contract, off contract mix, which doesn’t sound like you would expect that, would the gross margin impact basically go away as you start to lack the impact of the first quarter of ‘09?

Sam Martin

This is Sam Martin, Chris. You though, as that behavior becomes more stable, we should see it comp year-over-year. I think it’s the answer to your question.

Operator

Your next question comes from Gary Balter - Credit Suisse.

Gary Balter - Credit Suisse

Just two questions; one is, as we look at retail, the productivity has come down a lot over the last few years. We’ve done a good job of reducing expenses and you’ve closed underperforming markets. How do we think about profit levels in the future? Forget about 2010, but what type of productivity gains do you need to get back to margins that you used to be able to report or even better?

Sam Martin

Certainly, we need to see the same-store sales turnaround and become positive. We need to continue our disciplined approach to how we price and promote, so that we protect some of the margins at the gross margin level, and we need to hold onto the operating efficiencies that we have been able to achieve through the efforts of our operating theme through the last eight quarters.

Bruce Besanko

Gary, I’d just add to what Sam said, which is to say that we’ll talk more about this at our Investor Day, but in my heart of hearts, I believe that this company can have operating margins that are significantly higher than what we see today.

Sam Duncan

Our retail team has done a phenomenal job by getting costs out of the system. Paul Hertz and his team are amazing and what they’ve accomplished and we’ve done all of this in anticipation of some point the sales coming back and the economy improving. When we do that, we are going to be able to leverage sales quite nicely.

The process that Paul has put into play, we feel very good about holding onto the improvements that he and his team have made. So we’re setting very nicely for when the sales does return from the improvements in the economy.

Gary Balter - Credit Suisse

Effectively, you’ve lowered the breakeven significantly, we should be thinking about the term of productivity point of view? Second question, I don’t want to say you’re conserve in your guidance, but you talked about the bonus accruals and the fact you’ll have more in the first half this year, but you also guided us to effectively up earnings and flat earnings in the first quarter and then not much improvement for the full year.

If you could do kind of flattish in the first quarter, would the bonus accruals and you’re going then compare in third and fourth quarter against what you’ve talked about already this year, doesn’t that seem a little on the conservative side?

Bruce Besanko

I would say that we remain quite cautious in terms of the macro environment. There’s still a very high unemployment, which is a significant driver to our business. So what we do is we plan conservatively and we try to beat it, but at this point what we said in terms of outlook is what we believe will be the case.

Sam Duncan

The economy has improved, but we don’t want to get the cart before the horse. We hope it continues. We feel very good about the slight improvements that we’ve seen, but we will remain cautious.

Operator

Your final question comes from Mitch Kaiser - Piper Jaffray.

Mitch Kaiser - Piper Jaffray

A quick question, I know Rubin was conducting a network study and it sounds like you’re making some investments on the IT side and maybe it’s a topic for March 4, but could you give us some sense for where you stand on network study and what you might be doing there?

Sam Duncan

Yes Mitch, Rubin will be at New York when we do the Investor Day and he will be able to give you more color. Our network study is something that’s ongoing, that we have done since I’ve been with the company anyway and also since Rubin has been with the company. We’ve made great progress there, and Rubin and his team has done phenomenal work in our supply chain both on the warehouse side and on the supply chain side.

We feel good about where we’re at, so we will probably make some more changes this year and next year, but we’ll just add more color to that if you don’t mind waiting until a couple of weeks when we’re in New York.

Mitch Kaiser - Piper Jaffray

Bruce, just to give us a sense for how the incentive comp accruals kind of trend throughout the year, the numbers that Chris was throwing out, do they seem pretty reasonable? Because, I know that, it’s going to be a lot of commentary about that or people trying to assess what impact that might have.

Bruce Besanko

He seemed to put it on a per share basis. I would say that the number for 2009 is approximately $65 million that the number for 2010 is in that order of magnitude and that it is pro rata over the course of each of the four quarters.

Mitch Kaiser - Piper Jaffray

So it depend again, the ‘09 numbers are going to be much more weighted towards the back half than the first half?

Bruce Besanko

I’d say that we have a headwind in the front half because we have a bigger accrual this year than we did in 2009, and then we have a tailwind in the back half and there was one other comment I just want to make. I think Brad might have asked about the 2008. I was actually thinking of the 2007 initially, 2008 we didn’t pay much of a payout at all. So there was quite a bit of gap between what we paid out in 2009 and what we paid out in 2008.

Sam Duncan

Thanks, everyone for joining us. We’ll see most of you or all of you in New York in a few weeks. Thank you.

Operator

This does conclude today’s conference call. You may now disconnect.

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