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Staples, Inc. (SPLS)

Q3 2006 Earnings Call

November 14, 2006 8:00 am ET

Executives

Ron Sargent - Chairman, CEO

John Mahoney - Vice Chairman, CFO

Laurel Lefebvre - VP Investor Relations

Mike Miles - President, COO

Joe Doody - President, North American Delivery

Demos Parneros - President, U.S. Stores

Analysts

Bill Simms - Citigroup

Joe Feldman - Telsey Advisory Group

Armado Lopez - Morgan Stanley

Matthew Fassler - Goldman Sachs

Michael Baker - Deutsche Bank

Collin McGranahan - Sanford Bernstein

Dan Binder - Buckingham Research

Mark Rowen - Prudential Equity

Chris Horvers - Bear Stearns

Danielle Fox - Merrill Lynch

Presentation

Operator

Good day, ladies and gentlemen and welcome to the third quarter 2006 Staples earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today's call, Ms. Laurel Lefebvre, Vice President of Investor Relations. Please go ahead, ma'am.

Laurel Lefebvre

Good morning, everyone and thanks for joining us for our third quarter 2006 earnings announcement. During today's call we will discuss some non-GAAP metrics such as return on net assets, to provide investors with useful information about our financial performance. Please see the financial measures section of the Investor Information portion of Staples.com for an explanation and reconciliation of such measures and other calculations of financial measures that we use to analyze our business.

I would also like to remind that you certain information contained 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.

I would also like to remind you that we have restated our 2005 results to reflect the impact of expensing stock-based compensation and we will refer to those restated numbers when comparing our 2006 results to the prior year.

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 U.S. Stores and Joe Doody, President of North American Delivery.

Ron Sargent

Thanks, Laurel. Good morning, everybody. I am very pleased to announce excellent third quarter results with strong performances in each of our three businesses. To quickly run through the headlines, earnings per share were up 30% to $0.39. That includes adjustments related to tax and stock-based compensation which John will discuss later in the call. Excluding these items, net income grew 18% to $265 million, and earnings per share were $0.36, a 20% increase versus third quarter 2005. We're very pleased to see continued acceleration on the top line with sales growth of 12%.

Looking at the three business units, North American retail same-store sales were up a strong 4% and total sales were up 9%. North American delivery continues to gain market share with top line growth of 16%. International sales were up 10% in local currency, or 15% in U.S. dollars with strong 5% comps for Europe and continued progress in the UK and France.

Just a few weeks ago, we hosted our annual investor conference here in Framingham so we won't spend much time today revisiting our plans for the future. For those of you who did not attend, the theme for our investor day was driving profitable growth. We outlined our strategy to grow sales 10% to 15% and our bottom line 15% to 20% for the next few years. We also detailed some of the key growth platforms that will get us there, including our plans to expand into new geographies, to acquire new customers and to sell our customers a broader range of products and services.

There were seven key ideas that we discussed and I will briefly recap each:

  1. Our store model works; in existing markets, as well as new markets. By focusing on what customers want, our in-store experience is becoming increasingly differentiated. I think Chicago has been a proof point and we plan to repeat that success with entries into Miami, Denver and ten other major markets we're not in today.
  2. We have a terrific opportunity to improve store productivity by growing our offering in services. Our copy and print business has been a homerun in stores and we're expanding this business into standalone shops, and into our delivery business. Tech Services is another big idea, and we're growing this business aggressively as well with plans to have in-store technicians chain-wide by the end of the year.
  3. Staples brand products has plenty of room to grow. We announced our new target for Staples brand going from 20% of sales to 30%. We continue to launch innovative Staples brand products and we believe that direct sourcing will give us an incremental margin lift.
  4. We're building the brand by partnering with other retailers. Staples brand products will be in 2,500 grocery stores by year end, with many more to come.
  5. We're winning with delivery. We expect to grow this business by 15% for the next several years, following 16% to 18% growth in each of the last eight quarters. We also expect to improve our delivery inventory turns from 12 times today to 15 times.
  6. The turnaround in Europe is underway with good progress in the UK and France, and it is now showing up in the numbers. The momentum is building, and year-to-date sales for our international segment are up 7%; profits are up 120 basis points.
  7. Last, we've got great teams in Asia and South America and we fully expect that these emerging markets will play a big part in our success in the not too distant future. We expect to continue to drive rapid growth while maintaining profitability.

Just to summarize, our vision is for Staples to be the world's best office products company. This means we are going to stay focused on what Staples is known for: great execution that is focused on solving our customer's problems. We also have to continue to differentiate our brand in the minds of our customers, and we have to continue to drive market share gains by winning with more customers in more places, wherever we do business around the world.

I will now turn it over to Mike Miles to talk about third quarter results in North America.

Mike Miles

Thanks, Ron. Good morning, everybody. Let's start with the results for North American retail. Sales for the quarter were $2.7 billion, up 9% versus Q3 of 2005. Same-store sales were up 4%, driven primarily by strong traffic but also higher average order. We had a great back-to-school season; well-planned and well-executed. We also enjoyed strength in core office supplies, laptops, copy and print services and ink throughout the quarter.

New store productivity remains strong and we're very pleased with the portfolio of stores we're opening this year. North American retails SBU income improved 15% versus last year's third quarter, reaching $289 million. Operating margin rose 50 basis points year over year to 10.8%, driven primarily by gross profit leverage. Gross margins expanded due to strength in high margin categories like copy and print, and core office supplies, and good progress on attaching higher margin product to laptop sales.

We also did a good job controlling operating expenses. During the quarter, we completed the roll-out of our self-service payment systems in copy centers throughout Canada. These systems allow customers to complete their transactions right at the copier and also reduce the amount of unaccounted copies made. We expect to complete the installation of these systems in the U.S. during the first half of 2007.

In Q3, we opened 31 new stores in the U.S. and six new stores in Canada, so at the end of the quarter, we operated 1,576 stores in North America. For the full year, we're on track to open a total of around 100 stores here, with about 80 in the U.S., and 20 in Canada. This includes the new standalone copy and print shops that we're testing in the Boston market. In 2007, we expect to open more than 100 new stores in North America, including stores in Miami and Denver; new retail markets for the company. We now operate 625 Dover format stores.

We continue to focus on improving customer service and providing an easy experience for our customers. In Q3, our customer satisfaction scores were the best ever for our back-to-school season and we experienced a significant increase in customer compliments compared to last year. We delivered on Easy during back-to-school through an effective marketing campaign, innovative and colorful product to get teens organized, good in-stock and solid service, including some new technology for line busting called Fast Forward that shows customers we're committed to quick checkout.

We continue to make investments to gain market share and our consistent execution has positioned North American retail for sustainable, profitable growth and a differentiated customer experience.

Moving on to North American delivery, the NAD team achieved terrific results again this quarter, with strong sales growth in each of its three businesses. Sales grew 16% to $1.5 billion versus the third quarter of 2005, with organic growth accelerating almost a full percentage point from the second quarter. North American delivery achieved double-digit growth in each of our major product categories. Ink cartridges, paper, and janitorial and breakroom supplies showed particular strength.

Our contract business grew the fastest again this quarter, through new account acquisition and increasing share of wallet with existing customers. Our online and catalog business, Staples Business Delivery, benefited from its targeted marketing efforts, strong online promotions, and high customer conversion rates on Staples.com.

Quill grew sales as it benefited from strong own-brand product sales as well as increased share of wallet within its existing customer base. Worldwide ecommerce sales in the third quarter were $1.2 billion, a 27% increase year over year. Electronic sales represent 90% of total sales in our contract segment and 74% of sales for North American delivery overall.

SBU income increased 21% to $161 million, or 10.8% of sales, a 40 basis point improvement over last year's third quarter; a solid performance despite continued pressure from distribution expense.

Margin gains in North American delivery were offset by transition costs for our three new fulfillment centers. In addition to the Orlando and Atlanta FC's, we opened a new facility in Beloit, Wisconsin in Q3 to serve our Midwest region, including our Chicago customers. We plan to add to our distribution network in 2007 as well, with a new trichannel fulfillment center opening in Denver next spring. While bringing on new capacity hurts our expense rates in the short run, it provides the capacity to sustain our mid-teens growth rate and ensure great customer service.

Despite the short-term challenges of opening these FCs, we are very pleased with our customer service metrics during the quarter. Staples Business Delivery customer service has been certified for the second year in a row by JD Power and Associates for providing an outstanding customer service experience.

With that, I will turn it back over to Ron to talk about international.

Ron Sargent

Thanks, Mike. Sales for the third quarter were $586 million, that's up 10% in local currencies and 15% in U.S. dollars versus Q3 of last year. SBU income increased nine-fold to $9 million or 1.5% of sales; that's 130 basis points improvement over last year's Q3 results. We're seeing top line momentum in both our UK and French businesses. These represent the critical components of driving European results.

In retail, we're pleased with our overall profit improvement with strong comps of 5%. That's our best same-store sales performance since 2001. We're particularly pleased with our progress in the U.K. where comps improved to flat after three years of negative same-store sales. Store standards and merchandise presentation in the U.K. continue to improve and we're launching a new advertising and direct mail campaign to build our small business customer base. We're also encouraged by the growing mix of small business customer traffic in the U.K. I think it demonstrates that our marketing focus is working.

All of the other countries in the retail portfolio in Europe are performing well, with strong comps in every geography. No new stores were added during the quarter and we ended Q3 with a total of 262 stores in Europe.

On the delivery side, the operating margin rate in Europe improved nicely year-over-year with strong top line growth. Our French catalog business is beginning to reap the benefits of our investments and segmented marketing programs, customer service and systems, and we're building strong sales momentum.

Turning to new markets, China and South America are performing on plan with rapid growth in both businesses, particularly in China, where we expect to approach $100 million in sales this year. During the third quarter, we completed our joint venture agreement with UB Express in Taiwan.

In summary, top line trends are encouraging in Europe and we're confident that we can dramatically improve this business and achieve our operating margin goals of 7% to 7.5% in the next three to five years.

Now I would like to turn it over to John Mahoney to review our financials and our outlook.

John Mahoney

Thanks, Ron. I will go through the financials and give you some additional color on what is driving our results and then provide some guidance on our expectations for the fourth quarter and next year.

First, let's cover the tax rate and stock compensation adjustments, starting with the tax. Our Q3 results include a $33 million reduction in income taxes related to changes in estimates regarding certain tax uncertainties and the favorable resolution of several tax matters. This increased reported EPS by $0.04 per share. Our effective tax rate applicable for results from continuing operations remains at 36%.

In terms of stock compensation, during the third quarter of 2006 we completed a comprehensive review of our historical stock option practices for grants made during the last ten years. Based on the results of the review, we recorded a $10.8 million expense or $8.6 million net of taxes in Q3, to reflect the cumulative impact of accounting errors due to the use of incorrect measurement dates, without restating any historical financial statements. This represents about a $0.01 of earnings per share in the third quarter of 2006, and the impact of this correction in any single year would have been no more than 0.6% of the previously reported operating income for that year. We have concluded that the use of incorrect measurement dates was not the result of intentional wrong-doing and we have taken steps to improve our controls over our option granting process.

Turning back to our Q3 results, total company sales of $4.76 billion were up 12% versus last year's third quarter. Excluding the currency benefit in our Canadian and international businesses, sales grew 10.6%. Gross profit margin decreased by 11 basis points to 28.64% during the quarter, due to a strong margin expansion in our retail business, offset by deleveraging and delivery, primarily due to higher distribution expense and modest pressure from paper costs and fuel expense.

Operating and selling expenses for Q3 were 45 basis points favorable versus last year's third quarter, at 15.93% of sales. This reflects strong marketing expense leverage in our North American delivery business, solid expense management at retail, and good improvement across the board in our international businesses.

Turning to general and administrative expense, G&A deleveraged by 22 basis points for the quarter to 4.19% of sales, reflecting good expense control offset by higher variable compensation expense in line with our strong earnings performance, but primarily the correction of the measurement dates used to calculate prior years stock-based compensation.

Moving on to the balance sheet, total inventory turns were up 13 basis points versus last year, to 15.79 turns. We're sustaining our inventory turn improvement through continued focus on our summit supply chain programs at both retail and delivery. Return on net assets for the year improved to 13.8%, up 160 basis points compared to the end of the third quarter a year ago. This is an important milestone for us, as exceeding our long-term cost of capital of 11.7% by 200 basis points is a goal we've been working towards for several years.

Our liquidity and financial resources remain very strong. At the end of the third quarter, Staples had $2.1 billion in liquidity, including cash and short-term investments of $1.3 billion, and available lines of credit of about $800 million.

During the third quarter, we repurchased 7.3 million shares under our $1.5 billion stock buyback program, bringing our total repurchases to about $670 million under the current authorization. We have about $830 million remaining on our authorization. Our weighted average shares outstanding declined by just over 11 million shares year over year for the quarter, as a result of our repurchase program, offset by stock option exercises.

Year to date, CapEx came in at $352 million up from the $289 million we spent for the same period in 2005, primarily reflecting investment in stores, our new fulfillment centers and systems. With operating cash flow of $629 million, we generated $277 million in free cash flow year to date. Based on a little over $500 million in planned capital expenditures for the full year, we expect free cash flow generation of about $700 million this year.

In terms of our outlook for the fourth quarter, remember that we will benefit from an extra week in Q4. As a result, on the top line we expect high teens growth for the total company, with a positive low single-digit comp in our North American retail business. Note that we will exclude the 53rd week from our same-store sales calculation for Q4. Including the extra week, we expect mid-teens top line growth in North American retail; growth in the low 20s in North American delivery; and high single to low double-digit sales growth in the international business, in local currency.

We expect earnings per share growth will be slightly higher than 20% and keep in mind that the extra week, and the way fixed expenses and vendor promo flowed during the quarter, will impact a number of lines on the P&L in Q4. For the full year, we expect EPS growth to exceed our previous guidance of 15% to 20% growth, excluding the third quarter tax benefit and the correction for prior year stock-based compensation. We expect low double-digit growth on the top line, and positive low single-digit comps for North American retail.

In terms of our expectations for 2007, adjusting for the 53rd week in 2006, we expect our revenue growth in the 10% to 15% range, or about 8% to 13% including the extra week in 2006. We expect positive, low single-digit comps in North American retail; after adjusting for the extra week, we anticipate mid-teens revenue growth in NAD and in international, we expect low double-digit growth in local currency.

We expect next year's earnings per share to grow in the range of 15% to 20%, again after adjusting for the extra week, the Q3 settlement and the correction to prior years stock-based compensation. This equates to a range of $1.43 to $1.49 for 2007. We expect to invest approximately $525 million in capital next year.

Thanks for your time this morning. Now I will turn it back over to our conference call moderator for questions and answers.

Question-and-Answer Session

(Operator Instructions) Our first question comes from Bill Simms - Citigroup.

Bill Simms - Citigroup

Thank you and good morning. I have two questions; one for John, one for Ron. Surrounding the fulfillment center cost, you can give us an update on what the three fulfillment centers cost? The timing of how much of those costs have already been accounted for; what is left for the remainder of the year? And then looking to 2007, you said you would open one additional fulfillment center. So should we assume roughly one-third of the cost of what you spent in this year? Could you give us any transparency there?

John Mahoney

As I think we talked about last quarter, there are really several different factors in increasing the expenses associated with our fulfillment centers. The first is the write-off of the assets relating to the old fulfillment center which we had some spill-off when we opened our Beloit facility this quarter.

The second is transition costs, extra working hours, overtime, and duplication between two facilities as we run the two facilities at the same time.

The third is the relatively higher fixed cost base that comes with opening up incremental capacity as we expand our distribution network. So all of those things are moderating. We obviously had two of the facilities opened up earlier and the third one this quarter. We expect continued improvement in the fourth quarter in our ability to ramp up the productivity in those facilities. So we think that all in, we have seen the kind of expected improvement that we were planning when we opened these facilities and it will get better in the fourth quarter and it will be better for all of next yea.

As you say, we have one facility opening up next year. Because it is a brand new facility, we don't have the write-off costs associated with the facilities we opened up this year. We also won't have as much in the way of transition costs because we're not going to operate two facilities at the same time. So largely it will be productivity and start-up costs resulting from training the workers in that facility.

Overall, we're optimistic about seeing continued improvement in our distribution starting in the fourth quarter and throughout all of next year.

Bill Simms - Citigroup

Thank you. Ron, just one question on international third quarter operating margin. There is improvement from the second quarter, but I think there still is a long way to go. Is the UK still dragging down profitability? That is the biggest area of drag. What is your outlook for driving improvement in the UK?

Ron Sargent

I do think it’s a mixed bag. I think the UK is still dragging profits down a little bit, but I will tell you, we are getting closer and closer all the time and we're expecting to see continued improvement in the fourth quarter. I think it is also reflects some investments that we're making, primarily in Eastern Europe and primarily in some of the small markets that we're trying to grow very rapidly.

So do I think we have a long way to go? I do. We're making progress every quarter this year. I think we're going to make progress every quarter next year, but I fully expect that you will see a continued improvement in the fourth quarter, which typically is our strongest quarter of the year. I think all of the trends that I'm seeing, and when you look at the kind of work that Dick Neff and the UK team are doing over in the UK, I feel increasingly more confident that we're going to get to that 7.5% operating profit.

So I think in terms of operations, French delivery business seems to be growing the top line which I've been waiting for; the UK seems to be improving operationally. Then we will have to make our own decisions about what do you do in places like Eastern Europe or South America or Asia or Scandinavia in terms of how much we want to invest. But we're feeling a lot better about our European business today than we have in several quarters.

Bill Simms - Citigroup

Thank you very much. Good luck.

Ron Sargent

Thanks, Bill.

Operator

Your next question comes from Joe Feldman - Telsey Advisory Group.

Joe Feldman - Telsey Advisory Group

Good morning, guys. On the North American delivery business, how much growth would you say is coming from new customers versus the share of wallet? If you can break it down percentage-wise in some way and maybe by business as well?

Ron Sargent

Let me ask Joe Doody who is here who runs our North American Delivery business to answer that question.

Joe Doody

Joe, I won't break it down exactly for you, but it is a major part of each of the three businesses within NAD. We believe -- and certainly have shown evidence -- that we've got a great customer acquisition model in each of those three businesses. But in addition to that, we've got penetration taking place in terms of key core products into existing customers as well as share of wallet expansion into new categories, noted the JAN/SAN growth, but other categories as well that we're growing significantly. So it is a major part of each of the three businesses. But by no means is all of the growth that we're seeing in the business.

Ron Sargent

Would you say the mix would be tilted more towards new customers versus more sales to existing customers?

Joe Doody

Slightly more; yes, Ron.

Joe Feldman - Telsey Advisory Group

Can you give us any initial color on the initial Miami stores, and even the standalone copy and print centers?

Ron Sargent

Demos Parneros, who runs our North American retail business, can answer that one.

Demos Parneros

Sure. Good morning. First in Miami, actually we've been expanding into the Southern Florida market for the past year and with six additional stores up and running now, we're encouraged with those results. South Florida has been good for us prior to this entry; Florida actually in general has been strong for us, so we're not surprised by the good performance.

The one thing I'm personally proud of is the outstanding job that our team has done with customer service. The South Florida customers have absolutely accepted Staples and are really enjoying the store. So I would say so far, so good on the South Florida market entry. The same for the standalone copy centers. In that case, we're much newer in that arena. We've just opened our second store actually about a week ago, and the first store opened roughly a month ago. As you know, these are small, 4,000 square foot stores located in prime real estate locations in urban markets. We've had tremendous success with our Copy Center business and this is just an extension of that. So far, so good. It is a full service Copy Center. The key is also the very strong office supplies assortment that we have in these stores, which includes things like ink, paper and some of the other key small business needs. So we're very encouraged by both.

Joe Feldman - Telsey Advisory Group

That's great. Thanks very much, guys and good luck in the next quarter.

Operator

Your next question comes from Armado Lopez - Morgan Stanley.

Armado Lopez - Morgan Stanley

Thanks. Good morning, everyone. Just to follow up on the copy center question that was asked previously. As you look at the growth in copy centers within the stores, could you make talk a little bit about what you're seeing? Are you still seeing the growth accelerate there? Is that growth coming principally from new customers versus just gaining a larger share of wallet for your existing customers?

Demos Parneros

Good morning, Armado. We are very encouraged with progress in Copy Center. The growth is actually coming from both. We are seeing a lot of new customers trying the Copy Centers in our stores. One of the reasons for that is the great promotions that we've had. We have had great promotions for things like $0.39 color copies, as well as big poster or wide format color copies, or black and white copies. A lot of customers have really been turned on to those services and have begun to explore other services that we offer.

Alongside that, our existing customers also love the promotions and have continued to reward us with more business and our average order continues to grow. So we're seeing strength in existing as well as new customers trying the centers.

Armado Lopez - Morgan Stanley

In terms of the fulfillment centers and the rollout, could you provide a little more color in terms of where are you from a capacity utilization perspective? How long does it typically take to get one of the fulfillment centers up to full capacity?

Joe Doody

We typically build our new centers to last us, before expansion of that facility, in the three to five-year time period. Then we would typically go in and expand that existing facility to take on more capacity. So typically, we're building a new facility for three to five years of volume within that geography, with an expansion after that time.

Mike Miles

I can just add to that a little bit and say that when you think about the rate of growth we've seen in NAD sales, we have to really think about expanding to keep up with that growth. You think about mid-teens growth, it shows that your capacity is going to need expansion in a hurry. Coupled with that, we've found that our Summit supply chain initiatives have allowed us to get more capacity out of our existing facilities by process improvement and systems improvement.

So I think we have added fixed capacity this year at a fairly high rate, after not having added any for several years before that. So we think we're in good shape to have a little bit less lumpy performance in distribution expense going forward.

Armado Lopez - Morgan Stanley

Okay. Great. Thanks a lot, guys.

Operator

Your next question comes from Matthew Fassler - Goldman Sachs.

Matthew Fassler - Goldman Sachs

Thanks a lot. Good morning. John, if you could give us just a little bit of color on how you see both the fuel cost issue for distribution and the paper price issue evolving over the next couple of quarters? It would seem like certainly on the fuel side you're likely to see some benefit. If you can give us a sense whether that is a measurable amount that can impact the P&L or whether it is something that we wouldn't really see?

John Mahoney

I think on fuel first, we've seen diesel prices have been a little bit stickier than gasoline prices and you hear a lot of retailers talk about the benefit of lower gas prices. That hasn't been passed through to diesel fuel as quickly, so we have seen diesel prices higher than last year throughout the first three quarters of this year. We expect that will decline and create some measurable benefit, but it is not going to be certainly all that material to us.

The paper issue seems to have settled down in that as you probably know, we pass along in the delivery business our paper costs based on a rolling 12-month average in contract; therefore, it takes a while for the price increases to catch up, and the good news is that we haven't seen a paper price increase in the back half of the year and don't expect to, so we should start to see a little bit of benefit from that both through the remainder of this year and then on through the first half of next year.

Matthew Fassler - Goldman Sachs

Ron, just a quick question on international. It sounds like you're emboldened at this point to start marketing the improvements that you have made and to commit some dollars particularly in England where I think you've been hesitant to do that in the past. Did that start this quarter? It seems like at this point you probably have the option of maybe booking some nicely higher profits based on the work that you've done or engaging in reinvestment mode. Just how are you thinking about that those options as you look forward to next year?

Ron Sargent

In specifically the UK, I think we wanted to get the operations right and I think Dick and the UK team have done a wonderful job doing that. We did start some marketing this quarter, but it is primarily a different approach to marketing, it is more direct marketing and building our small business customer base through rewards and direct approaches, and direct mailing, versus putting computers on the front page of the circular around the country.

So I think we've cycled maybe the bad marketing, and we've started on the good marketing and we are going to step on the gas a little bit in the fourth quarter and beyond, because we've had negative comps there for a couple of years, and now that we're seeing our customer count trends heading in the right direction and our comp sales heading in the right direction, you can be sure that we're going to step on the gas just a bit.

Matthew Fassler - Goldman Sachs

Just to clarify Ron, have you really marketed this way before? As you think back to your ten-plus years in the country, are these tactics different from what you pursued previously?

Ron Sargent

I think if you look at the last few years, it is certainly different. I think when you we started in the UK it was back in 1991 and I think we were really focusing on that small business customer for several years and we had good results to show for it. I think over the last three or four years, I think we got a little bit astray of how we market in the U.S., and I think we were spending too much time doing Sunday newspapers and circulars and giving away technology at low margin and little attachment.

So I think only in the last 18 months really, since Dick's arrival and we sent over some resources from our direct marketing team in the U.S., I think only in the last 18 months have we cycled the computer promotions and have started on the direct approach. So like I said, I'm pretty encouraged about the progress we're making in the UK.

Matthew Fassler - Goldman Sachs

Thank you so much.

Operator

Your next question comes from Michael Baker - Deutsche Bank.

Michael Baker - Deutsche Bank

Thanks, a couple of questions. One, I think at your meeting you talked about the retail business potentially growing at 10% on a longer-term basis. This is a great quarter, but what gets better to get to that 10% where retail only grew at -- a very good number, but I think 9% this quarter?

Mike Miles

I think the formula that we have for getting to that 10% is high single-digit square footage growth, 6% to 7% square footage growth and then low, but at the upper end of the low single-digits from a comp sales basis every quarter. I think what you saw this quarter is indicative of our aspirations to get there. Getting to the double-digit is an aspirational thing for us and that is the challenge that we've set out for the marketing, merchandising and real estate teams. Those are the two things that will get us there.

We're optimistic that some of the services businesses that we're growing, as well as some of the new formats from a real estate standpoint, will help add to what you saw in this quarter.

Michael Baker - Deutsche Bank

That high single-digit square footage, 6% to 7%, I think it is a little bit of an acceleration. Is that because you're including some of those newer formats or are you going to step up this year's core superstore growth relative to where it's been? Related to that, would that be a reaction to what some of your competitors are doing?

Separately, if you could comment on what you think about some of your competitors’ increased square footage growth?

Mike Miles

Well, we've been increasing the number of stores that we've been putting into North America every year for the last several years. Our increase in that is a reaction to the success that we're seeing doing that. It is not a reaction to what anybody else might be doing. But our take on the North America market right now is that it remains a highly fragmented market and there is a lot of opportunity to add new stores.

I think the new format stores at the margin, will play a role in the increase in square footage, but the bulk of the increase in square footage is going to come from the Dover superstore that is really the backbone of the chain. The results that we've had this year and last year both with new market entries and adding stores to the markets that we've been in for a long time have been real positive. Some of the best new store openings we've had this year have been in markets like Boston and New York, where we've been for 20 years now, and we can see opportunities in new markets and the existing markets as well.

Michael Baker - Deutsche Bank

Thanks for the color.

Operator

Your next question comes from Collin McGranahan - Sanford Bernstein.

Collin McGranahan - Sanford Bernstein

Good morning. John, I think you said that you saw strong gross margin expansion in retail. I was hoping you would provide a little bit more color on that, given the strength in back-to-school and obviously technology was one of the better categories; and maybe what the impact of private label was? Just if you could expand on the gross margin expansion in the retail division a little bit.

John Mahoney

Sure. Back-to-school is a great time of the year for us because it does have a pretty rich mix of office supplies, and our comps in office supplies were better than technology, even though technology is very good. Our mobility initiative, which focuses on not just selling laptops but also all of the attachments that goes along with it, also has helped our margin in technology. We do a little bit better there than we did before we were getting the level of attachment that we've seen.

The Staples brand continues to increase its penetration. As we said, we're going to get to the 20% goal that we had set for ourselves previously this year, which is a nice improvement. That also helps our margin. Finally I would say that the mix of particularly Copy Center business which is higher margin than the rest of the chain and is growing at a multiple of the chain, helped.

So really there are an awful lot of things working together to improve our gross margin in the North American retail business and we think that is something we expect to see going forward as well.

Collin McGranahan - Sanford Bernstein

John, you mentioned also that the extra week in Q4 will have impact on multiple lines. Do you care to expand on that at all? Just what we should be thinking about as we model out Q4 a little bit more carefully?

John Mahoney

I think as you think about gross margin, for example, we do our promo money, the arrangements are 52-week arrangements with vendors so we will have effectively one less week of promo money; so we will have 14 weeks of sales, and 13 weeks of promo money. That will impact our gross margin a little bit. Similarly in other lines, some of the operating expense lines, where you see fixed costs like rent, where we have 13 weeks of rent in some cases that results in lower expense rates there. So nearly every line in the P&L will have some impact associated with that. We just wanted to make sure that as you model those things, that you take that into consideration.

Collin McGranahan - Sanford Bernstein

So directionally, a little bit less gross margin benefit, a little more expense benefit and we can model around that?

John Mahoney

That’s right.

Collin McGranahan - Sanford Bernstein

Finally, just on the fulfillment centers, not to beat a dead horse here, but is the opening and the schedule pretty much as you expected, or has something lagged or not come up as quickly? How are you thinking about the expansion of fulfillment centers this year versus what you had originally anticipated at the beginning of the year?

John Mahoney

Well Colin, as you might imagine, with three projects the size of that nothing ever goes exactly the way you expected it to. That said, each one has a different story and some level of associates moving over, it varies by facility, and that has a lot to do with how quickly you get the facilities ramped up and operating properly. There is always new technology in facilities or technology that works together with something that has been there before that creates some challenges.

So I would say overall, we're about on plan. But we've had at least one facility do better than we expected and one probably do about what we expected and one probably do a little bit less than we expected coming out of the chute. You have to give a lot of credit to the team that has opened these facilities, and they have really worked day and night to get these things up and running; and are primarily focused on making sure that we get our packages to customers next day, on time.

As you heard, our perfect order rate remains very strong in spite of the fact that we've had this tremendous amount of transition during the year. Anything you want to add to that, Joe?

Joe Doody

Just the last point, John, is that we're extremely pleased with the level of service we're providing out of these facilities. Our customer service metrics are really at all-time highs and that bodes well for us in terms of retention of our customers and continued growth of our business with our existing customers.

Collin McGranahan - Sanford Bernstein

Great. Thank you very much.

Ron Sargent

Thanks.

Operator

Your next question comes from Dan Binder - Buckingham Research.

Dan Binder - Buckingham Research

On a year-over-year basis, if we look at paper it's up quite a bit on the pricing side. Even I think ink has seen some increases out of HP through the year. How much do you think that is helping the comps at retail and sales overall? It is meaningful?

Ron Sargent

I don't think it is meaningful. John could answer that question better than I.

John Mahoney

The paper price increases have been pretty gradual over the course of the year and it is certainly less than 50 basis points for the combination of both on the comps.

Dan Binder - Buckingham Research

Okay. I'm not sure if you commented, I jumped on the call a little late, but did you have any color on the furniture business, both at retail and delivery?

Mike Miles

We are pleased with the furniture business, which on the retail side, showed some growth in the third quarter, particularly thanks to the chairs business, which has been transformed, I think, with a focus on quality and has been performing much, much more strongly. We have had a little bit of margin pressure there as we go through some clearance to get some of the older collections out of the store, but I think that is going to set us up for a stronger year in 2007.

On the delivery side, furniture has been a real growth category for us and really hasn't suffered any of the issues that we've seen in the retail side, which again is some of the reason that we believe that the retail furniture business is very fixable and the progress that we're making is just the beginning of better things to come there.

Dan Binder - Buckingham Research

Just on the pricing side, I would maybe like to take a look at retail and delivery. Listening to some of the wholesaler calls, it sounds like that the independent dealer is still fairly strong. You guys are fairly strong. I'm just wondering how much of your growth in delivery do you think is really market share gains, given the strength of the independent dealers, out there, and how much of it is just a benefit of a really good economy?

The other thing I wanted to explore was just on the pricing side. Are you seeing any changes in the pricing environment in delivery?

Also on the retail side, the competition has been a little bit more liberal on the every day pricing, but more aggressive on the week to week promotional activity. Just a little color on that.

Joe Doody

From a delivery standpoint first, in terms of growth, clearly we're taking market share. Our growth in the mid teens is far above the rest of the industry, which is more in the low to mid single-digits, so there are clearly share gains going on.

From a pricing standpoint, it is always competitive out there, but yet fairly rational. One of our major competitors has gone on record to say that they need to drive more profitability and as such, are re-looking at how they're pricing in the marketplace, so we're seeing, for the most part, pretty rational pricing.

I will say that as you know, the paper increases in costs and what it relates to in our business is a little bit more noticeable than it is in retail, so it is maybe about a point of our growth in the most recent quarter is due to paper impact.

Demos Parneros

The thing I would add to Joe's comments is that our pricing philosophy continues to be focused on not just the office superstores that you mentioned but obviously everyone who is out there. As you know, there are a lot more players who we compete with every day than just the two. In addition to that, we will fully expect the heavy promotional activity as we end the year due to Black Friday and then the holiday season. So it will probably be the same as it was last year.

Dan Binder - Buckingham Research

Okay. Last question, just in terms of the business consistently through the quarter, did things hold up pretty well post back-to-school?

Ron Sargent

It was fairly consistent throughout the quarter.

Dan Binder - Buckingham Research

Thanks.

Operator

(Operator Instructions) Your next question will come from the line of Mark Rowen – Prudential Equity.

Mark Rowen - Prudential Equity

Thanks. On the pricing, when you go into new markets where two of your superstore competitors are already established, are the pricing trends in those markets different and more competitive than in markets where there are only a couple of players?

Demos Parneros

They're really not, actually. Surprisingly it has been quite rational. As you know, we've entered as the third player into several markets over the last few years and it has been rational pricing. Again, we will go in and do our grand opening program just the same way that competition comes in to some of our markets and does their grand opening activity. But essentially, the pricing is fairly consistent across the board.

Ron Sargent

We think pricing is just one element for how customers pick an office superstore. I think it is store format, store service once you get in there. I think it is knowledgeable people. It is not just pricing. People want a fair price but they won't run all over town to save a nickel.

Mark Rowen - Prudential Equity

But basically, there is no difference in markets where there are three players versus two or one?

Ron Sargent

Pretty much, it is pretty much rational pricing these days. I think those days are long gone.

Mark Rowen - Prudential Equity

Just as a follow-up to the pricing, John, when you look at your long-term operating margin goals that you set out at your analyst day, do you assume that pricing remains where it is, which I think everyone would agree has been benign in the industry, where nobody is really trying to use price as a way to gain share. Do you assume that continues going forward?

John Mahoney

Yes. I would say that our prices have continued to go down every year as we improve our supply chain and buy better. So I think we expect that we will continue to pass on benefits from some of our productivity to customers, but that pricing will stay in the similar environment to what it is now. Largely based on the fact, as Ron said, that customers tell us that they want to trust us for price, they want our prices to be good, but unless it is materially different, they aren't going to shop around for price as much.

Mark Rowen - Prudential Equity

Lastly Ron, on Europe, to get to your operating profit target of 7.5% what basically do you need to do from here? Is it primarily cost cutting or is it primarily you still need to improve the sales and get leverage on your fixed costs?

Ron Sargent

When you look at our European P&L and you almost have to look at it by country, I think you have to look at opportunities in every part of our business. In the UK it is certainly top line, I think there are certainly expenses. I think there is an opportunity on some G&A lines throughout Europe. I think you have to make decisions in other countries about how quickly do you grow them, and what are you sacrificing in terms of the bottom line in an effort to grow them quickly?

There are opportunities when you look at where our current operating profit rate is in Europe, I think it is very obvious that there are opportunities in every single line of the P&L and we're working every single line of the P&L.

Mark Rowen - Prudential Equity

Given that you have stated that you're relatively breakeven in some of the emerging markets and you seem happy to do that to grow the businesses as quickly as you can there, how much of a drag is that on your international margins now?

Ron Sargent

In terms of percentage, I would defer to John.

John Mahoney

As Ron indicated, we want to grow those businesses and have then breakeven but we have seen small losses in both China and in South America over the last couple of years. But it is a matter of hundreds of thousands of dollars, not millions; as a result, the impact is fairly small on the total bottom line. If we get our European business to start to achieve in the areas of better buying, and sharing best practices, and marketing productivity, it will dwarf the losses we're experiencing in those emerging markets.

Mark Rowen - Prudential Equity

Great. Thanks.

Ron Sargent

Thanks, Mark.

Operator

Your next question comes from the line of Chris Horvers - Bear Stearns.

Chris Horvers - Bear Stearns

Good morning, everybody. A follow-up on the real estate question. Ron, I think in the past, you've talked about a number of stores that you thought that the North American market could bear. I'm not sure if it was 4,500 or 5,000. If you could talk a little bit about that, and especially in light of the ramp-up at Depot and Max.

Ron Sargent

I think the number I've used in the past is 4,500 of the existing format office superstores. I don't think we're in any danger of saturation in the near future. I think the good news is it is a big market and a growing market, and when you look at all three office superstores put together, our share is pretty small. When you look at the fact that we've shown some success in entering new markets like Chicago and Southern Florida as well as new store openings, our new stores are opening strong there year than last; that represents, to me, the opportunity.

If you look at 4,500 and if you assume that we're probably 1,500 today, the optimist would say there is room for 3,000 Staples stores and the pessimist would add the three office superstores numbers together and say there is not much room left. So I think what we're seeing is a continued success in entering new markets.

We've got some other things coming whether it is a prototype for a new urban type store; whether it is a small store like Barrington, where I think we've been working to perfect that market. So do I think there is a lot room? I think there is. Frankly, our focus is more on customers than it is on competitors. Our plan is to make steady progress year after year, internally, we call that going 20 miles a day.

But briefly put, we're going to continue to focus on customers and execute our plan, and we have been stepping up the store growth each year for the last few years, and based on this year's results, my guess is we will step it up another notch next year.

Chris Horvers - Bear Stearns

How long typically is the real estate process from site selection to actual opening? How long is your pipeline and how do you protect against the winter's curse of going after, because you have three competitors going after the same good real estate location, and ending up overpaying for something?

Ron Sargent

Well, typically, it is about a year process from the time you identify something and in many cases it can be multiple years, if it is a full development that is going in and has to be permitted and approved. But typically we think of our pipeline about a year after we identify the stores, when we would open it.

In terms of competing for real estate, that's what we do. We try to get the best real estate and everybody else does as well.

John Mahoney

I would just add that I think we've shown great discipline in our use of capital and we have a store model and we know what we can afford to pay for rent and we are willing to pass on a location if the rent goes beyond what we can afford to get a good return on the store.

Ron Sargent

I think one of the things that John mentioned in his comments and something we're very proud of and we probably didn't play it up enough is 13.8% ROA we've been working for the last five or six years to get to 13.7% and we delivered 13.8% which I think it is a good indication we're spending our shareholders' money wisely.

Chris Horvers - Bear Stearns

Thank you.

Operator

Your final question comes from Danielle Fox - Merrill Lynch.

Danielle Fox - Merrill Lynch

Thanks, good morning. I just have a quick follow-up actually on the gross margin outlook. John, I'm wondering; does the 2007 outlook assume that gross margins are up on a consolidated basis? If so, what are the key drivers of that incremental improvement from recent trend? Is it the improvement in fuel and paper prices as well as the ramp-up of the fulfillment center you mentioned earlier?

I'm just wondering what specifically you put in for gross margin for next year?

John Mahoney

Danielle, the same drivers that have been working in retail are going to continue to work. We are going to continue to see an improvement in mix, whether it is from Copy Center or for other categories; we're going to continue to see the Staples brand improve and our supply chain initiatives will allow us to drive down the cost of bringing product from vendors on through to customers. So I think that will continue to be the same.

In NAD where we've seen a lot of pressure from adding capacity in our distribution centers, we're not going to see that same kind of pressure next year, so that will allow us to return to improving gross margins in NAD. So I think the combination of the two of those where this year you had the NAD margin pressure offsetting the gains we've seen in retail, will work together next year to allow our gross margins to improve.

Danielle Fox - Merrill Lynch

So sequential improvement. Do you anticipate that they will be up or we will see how things play out over the course of the year?

John Mahoney

I think we will see improvement year over year for all of next year.

Danielle Fox - Merrill Lynch

Terrific. Thanks.

Operator

You have no further questions at this time. I would like to turn the call over to Mr. Sargent for closing comments.

Ron Sargent

Just to wrap up, I would like to close by thanking the Staples team for delivering another really outstanding quarter. While we continue to improve margins, we're squarely focused on driving profitable growth and we're pleased to see the top line momentum in every part of our business.

Thanks everybody for your time this morning, and we look forward to speaking with you again soon.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation.

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Source: Staples Q3 2006 Earnings Call Transcript
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