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Staples, Inc. (NASDAQ:SPLS)

Q1 2010 Earnings Call

May 20, 2010 8:00 am ET

Executives

Mike Miles – President & COO

Ron Sargent – CEO

John Mahoney – CFO

Demos Parneros – President US Stores

Joe Doody – President North American Delivery

Analysts

Gary Balter – Credit Suisse

Brad Thomas – Kebanc Capital Markets

David Strasser – Janney Montgomery

Kate McShane – Citi

Matthew Fassler – Goldman Sachs

Chris Horvers – JPMorgan

Mitch Kaiser – Piper Jaffray

Colin McGranahan – Sanford Bernstein

Michael Lasser – Barclays Capital

Mike Baker – Deutsche Bank

Dan Binder – Jefferies

Joe Feldman – Telsey Advisory Group

William Truelove – UBS

Alan Rifkin – Bank of America

Stephen Chick - FBR

Operator

Good day ladies and gentlemen, and welcome to the first quarter 2010 Staples, Inc. earnings conference call. (Operator Instructions) I would now like to turn the presentation over to Laurel Lefebvre, Vice President of Investor Relations.

Laurel Lefebvre

Good morning and thanks for joining us for our first quarter 2010 earnings announcement. During today’s call, we will discuss some non-GAAP metrics to provide investors with useful information about our financial performance.

Please see the financial measures and other data section of the investor information portion of www.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 you that certain information discussed on this call constitutes forward-looking statements for purposes of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by such forward-looking statements as a result of various important factors, including those discussed or referenced under the heading Risk Factors and elsewhere in Staples latest 10-Q filed this morning.

Here to discuss Staples Q1 2010 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 with us are Demos Parneros, President of US Stores and Joe Doody, President of North American Delivery.

Ron Sargent

Thanks Laurel and good morning everybody. Thanks for joining us today. I’m very pleased to report a strong start to 2010. We’re seeing improvements in both the top and bottom lines in each of our three businesses and our team continues to execute extremely well.

Compared to last year total sales were up 4% to $6.1 billion, and adjusted earnings per share increased 27% to $0.28. We generated $144 million of free cash flow during the first quarter. North American delivery got back to growing with a 2% increase on the top line, and North American retail comped 1%, a 300 basis point sequential improvement in the two-year comp trend.

On the bottom line for the first time since the third quarter of 2007 we expanded operating margin in all three of our businesses. We saw particular strength in North American delivery, and international with both segments improving operating margin well over 100 basis points compared to last year.

With solid progress on the Corporate Express integration, and positive early results from our key growth initiatives we’re seeing good momentum to start off the year. Turning now to our business units, and I’m going to start with North American delivery, sales for the first quarter were $2.5 billion, an increase of 2% in US dollars.

The top line in each of our delivery businesses improved sequentially. In Staples business delivery we grew the top line in the mid single-digits. In contract, sales grew in the low single-digits, and Quill’s top line declined in the low single-digits.

In contract customer acquisition and retention remained strong. Sales from new customers drove top line improvement in the high single-digits. This was offset by lower spend from existing customers. The adjacent categories that we call our lines of business grew faster than the house during the first quarter with particular strength in promotional products, which had strong double-digit sales growth versus Q1 of last year.

One of our key initiatives in North American delivery is to grow facilities and breakroom supplies, an area where we’ve greatly improved with the acquisition of Corporate Express. We’ve expanded our assortment, sharpened our pricing, and ramped up our marketing efforts to drive awareness resulting in top line growth above the house during the first quarter.

NAD operating margin improved 162 basis points to 8.3% compared to the same period last year. Improved product margins, sales force productivity, warehouse consolidation, reduced amortization, and customers buying a broader range of products, all helped operating margin.

Throughout 2009 contract customers were cautious and shifted their mix to more on contract, lower margin products. During the first quarter of 2010, we saw an improvement in the mix as customers began to purchase more off contract items. This helped NAD gross margins by about 10 basis points during the quarter.

Turning to some of the operating metrics we continued to increase our average order size. For Q1 average order in contract was about $200.00, an increase of $7.00 compared to Q1 of 2009. We also reduced the percentage of small orders under $50.00 by a few hundred basis points compared to last year.

During 2010 our Corporate Express integration plans are going to be all about the supply chain. We continue making progress with our distribution and transportation network. After successful consolidations of facilities in Kansas City, and Orlando, we’re on track to consolidate another handful of fulfillment centers this year.

In addition to supply chain integration we’re also in the early stages of developing our single ecommerce ordering platform for all of our contract customers. Moving on to North American retail, sales for the first quarter were $2.3 billion which was an increase of 6% or 2% in local currency compared to Q1 of 2009.

First quarter same store sales were up 1% with strength in computers, tech services, copy and print, and office supplies. Customer count comps increased 3% compared to Q1 of last year but average order size was down about 2%.

Traffic trends in retail were stronger among consumers relative to small business customers, reflecting continued weakness in job creation. Our investments to grow business technology drove strong results across multiple categories. We have a very low share and relatively low customer awareness in categories like computing and tech services.

To take advantage of this huge market opportunity we’re investing in people, training, and store remodels this year. During the first quarter our top line growth was well above the house in computers, software, and peripherals. And our EasyTech business continued to grow very rapidly.

The average comp for these categories is up more than 10% for the quarter and margins were respectable as a result of good progress in attachment selling and inventory management. We’re also driving growth in our copy and print business by investing in training, technology, and store remodels, the sales force, as well as incremental marketing.

During the first quarter our copy and print business in North American retail comped several hundred basis points better than the house. And while we’re very focused on these two big growth initiatives in retail we’re still growing our high margin core office supplies business.

During Q1 office supplies performed better than the house with strength in writing instruments, business essentials, and dated goods. Cut sheet copy paper was also quite strong and ink comps were in line with the house.

North American retail operating margin increased 30 basis points to 7.6% for the quarter. We leveraged marketing, distribution, and rent expense and also saw a benefit from reduced depreciation. We held gross margins flat despite an increased mix of technology products.

We achieved a modest reduction in inventory per store despite growing the top line and drove about a 50 basis point improvement in inventory turns compared to last year’s levels. We also achieved record high customer satisfaction scores.

During the first quarter we opened 20 stores, we closed three stores ending Q1 with 1888 stores in North America. We’re on track to open about 40 new stores in North America for the full year.

And with that I’ll turn it over to Mike, to talk about our international business.

Mike Miles

Thanks Ron, good morning everyone. Sales for the first quarter in international were $1.3 billion, an increase of about 6% in US dollars, a decrease of about 4% in local currency compared to the same period last year.

Operating margin for the international business was 2.9% of sales, an increase of 121 basis points from Q1 2009. Our European office products business achieved a 4.1% operating margin, a 300 basis point improvement as a result of our integration efforts and aggressive management of unprofitable businesses.

In Europe the delivery business had a solid quarter, with positive sales growth in local currency and strong profit growth. We’re realizing the profit improvements that we’ve talked about before generating better margins through [pan] European buying, reducing G&A with our new European organization, and integrating our supply chain.

In the first quarter we further reduced the number of delivery warehouses by four and have now closed a third of the facilities we had following the acquisition of Corporate Express. European retail has been more difficult, with a same store sales decline of 5%.

We’ve reduced our emphasis on technology promotion and have refocused on building a retail business more based on office supplies. We were still able to hold our operating profit rate but we must develop new traffic drivers for this segment.

The integration of Corporate Express in Europe remains solidly on track. During the quarter we implemented in catalogues and inventories the brand and product changes resulting from last year’s vendor negotiations.

We completed the rebranding of our contract operations to Staples Advantage. The 2010 contract catalogues were launched in April, with Staples own brand products replacing all CE legacy brands. We also rebranded our retail stores in Norway to Staples.

In addition to the warehouse consolidations I just mentioned we have started to leverage our contract warehouse in the Netherlands to replenish our Dutch stores replacing direct to store deliveries from vendors thus realizing cost savings and better in stock.

The printing systems division produced a loss again in Q1 but sales have begun to stabilize and the cost reductions we’ve implemented there should make that division profit neutral for the balance of the year.

Our high growth markets generally showed improved sales trends as the economies of Asia and South America rebound from 2009. In addition to sales growth we need to drive higher gross margin rates in these businesses and we made good progress on that in China and Brazil this quarter.

As you might remember we have three priorities for driving our international business, people, profitability, and portfolio. We continue to add to our strong international leadership team. Yesterday we announced that [Pete Howard] who has been leading Staples Business Delivery has become the Senior Vice President for Southern Europe.

That region includes two of our most profitable catalogue businesses and Pete will look to reignite sales growth there. We will also have the benefit of his direct marketing and ecommerce expertise across all of international.

As I just described we continue to make strides in our profitability with strong improvement in Europe during Q1. We expect to improve our overall profitability throughout the year as we lap last year’s losses in China and printing systems.

On the portfolio front I said last quarter that we wouldn’t hesitate to pull back from unprofitable markets and noted the closure of our operations in Hungary and in Czech Republic. Obviously we prefer turning a business around to exiting a market and in the first quarter we saw most of our European businesses which suffered losses a year ago turn a profit.

Our portfolio strategy is equally focused on investing in priority markets and in Q1 we initiated a push into the mid market contract space in the UK. We also announced an offer to acquire the 41% of Corporate Express Australia that we don’t currently own.

The offer period extends through June and we think that Staples multichannel approach will work well in the Australian market. Now I’d like to turn it over to John to review the financials.

John Mahoney

Thank you Mike, for the first quarter total company sales were up 4% versus last year to $6.1 billion. The foreign exchange impact from the weaker US dollar helped the top line by about 400 basis points during Q1, with about half of this benefit coming from the strength in the Canadian dollar.

Our first quarter GAAP earnings per share on a fully diluted basis increased 30% to $0.26 versus the first quarter of 2009. Favorable foreign exchange rates benefited EPS by about $0.02 during the quarter.

During the first quarter the company recorded pre-tax integration restructuring expense of $21 million or $0.02 per diluted share. Excluding these costs as well as the $19 million of pre-tax integration and restructuring expense that we incurred during the first quarter of 2009 adjusted earnings per share increased 27% to $0.28 versus $0.22 during Q1 of last year.

Our effective tax rate for the first quarter was 37.5% compared to 34.5% last year. This change in the effective tax rate relates to the expiration of provisions in the IRS tax code regulating the way we report international income on our US tax return.

As a result our tax expense for the first quarter of 2010 was $10 million higher than it would have been if Congress had extended these provisions. Assuming Congress extends these provisions our tax rate for the year would return to 34.5%, and we would have a catch up adjustment that would reduce income tax expense in the quarter that Congress passes the legislation.

Gross profit margin improved by 50 basis points to 26.7% during the first quarter. This reflects stronger product margin driven by better buying and increased vendor support as well as efficiencies in delivery and distribution expense.

SG&A leveraged 45 basis points versus last year’s first quarter to 20.1% of sales. This was driven by reduced marketing expense, G&A efficiencies, as well as a modest reduction in depreciation expense as a result of lower capital expenditures last year.

Adjusted operating margin increased 107 basis points during the first quarter to 6.3% compared to Q1 2009. Q1 capital expenditures came in at $49 million with operating cash flow of $193 million, we generated $144 million in free cash flow for the first quarter.

We remain on track to spend about $450 million on capital expenditures this year as we invest in growth initiatives, new stores, remodels, systems, and the integration of our distribution networks in North America and Europe. And we expect to generate more than a billion dollars of free cash flow this year.

During the first quarter we increased our quarterly cash dividend by 9% to $0.09 per share. This equates to about $65 million of cash returned to shareholders through dividends during the quarter. Later this year we’ll also consider resuming our share repurchase program.

As we look out to the rest of 2010 we’ll face tougher comparisons on the top line particularly in North American retail. For the current quarter and the full year we expect total company sales to increase in the low single-digits versus 2009.

Operating margin comparisons get tougher throughout 2010 especially in North American delivery as we anniversary about 200 basis points of sequential operating margin improvement from Q1 to Q2 of last year.

We expect adjusted diluted earnings per share excluding integration and restructuring expense to be in the range of $0.18 to $0.20 for Q2. This assumes Congress doesn’t pass legislation extending the provisions in the second quarter resulting in a 37.5% tax rate.

Assuming we get back to the 34.5% tax rate for the full year, we expect adjusted diluted earnings per share in the range $1.25 to $1.33. We’re maintaining a wide range of earnings outcomes in light of the uncertainty of the sales trends in the back half of the year.

As the employment picture and other macro factors remain uncertain, if the top line improves faster than we expect, we’ll be closer to the top end of the range. We expect depreciation expense to be $120 to $130 million in the second quarter and $470 to $490 million for the full year.

Amortization expense to be about $15 to $20 million in the second quarter and $65 to $75 million for the full year. Integration and restructuring expense will be $15 to $20 million in the second quarter and $45 to $55 million for the year. And net interest expense to be about $50 to $55 million in the second quarter and $215 to $225 million for the full year.

In terms of share count you should expect about 735 million shares for the second quarter and about 740 million for the full year.

Thank you for your time this morning, and now I’ll turn it over for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Gary Balter – Credit Suisse

Gary Balter – Credit Suisse

Nice quarter, a couple of questions, one is can you talk about your thoughts on share buyback at this point.

John Mahoney

I guess as we’ve said we [see] stronger cash flow in the second half of the year so after we get through the period where we’re building inventory for the back to school period, would expect to address our share buyback program and assuming cash flows remain strong and nothing untoward happens, we’d rebegin our share buyback program sometime towards the middle of the year.

Gary Balter – Credit Suisse

And if we look at Europe could you go into a bit more detail, you mentioned obviously you’re seeing very, very nice results, it was a nice quarter because of the integration but the offset is that you’re seeing weakness in the retail side and the currency will stop being in your favor going forward so how should we be thinking about it as the year progresses and have you readjusted your goals for Europe given the weakness you’re seeing in some of the retail areas and obviously the weakness we see every day on television.

John Mahoney

Why don’t I answer the math question first and then Mike can talk about the operations, and I guess the math question is the impact of the euro, strictly speaking we expect that about 10% of our earnings are driven in the euro so a 10% shift in the value of the euro would impact earnings by about a penny a share.

That will be a little bit offset by the strength in the Canadian and the Australian dollar. But obviously to the extent that the decline in the euro or troubles in the European market effect the world economy, that would have a different impact.

Mike Miles

With respect to the operations the story for us in Europe this year is going to be about improving our margins and less about top line growth. Clearly we’ve got some work to do on the retail side and although we saw improvements in most of the retail markets that we’re in in terms of comps in Q1 we’re still not driving traffic the way we do in North America with really good office products offers to business customers.

Its been much more price item on technology and we need to get a better drum beat of sort of the ink and paper offers and ink and paper traffic. But with respect to the business overall I think that plans that we’ve got to drive margin improvements which I think you’re seeing the results of in the first quarter we’re going to carry on throughout the course of the year and so we expect absents John’s scenario or potential scenario of a real impact to the overall economy from this euro weakness we expect all of those plans to carry through and to have strong margin improvement and profit improvement in Europe this year.

Gary Balter – Credit Suisse

Could you talk about your thoughts on the small business customer right now, obviously you haven’t seen the strength you want to see but you actually had some pretty good [BSD] or North American delivery numbers, are you seeing any indications that they’re starting to come back or are they still waiting because they’re worried about the economy and worried about Washington.

Ron Sargent

I think they are coming back and I think again I’m not an economist but I am kind of optimistic about the economic recovery that we’re starting to see. Our business is coming back just like it did in the last recession and I think that bodes very well for the company in 2010, 2011, 2012. Obviously the economic indicators are really mixed and we’re seeing in the first quarter some choppy sales, kind of up and down, but from my perspective the key is job creation and our job is to take care of customers, invest appropriately, run a tight ship.

But there’s some real positive signs we’re seeing. The mix of off contract to on contract in our contract business, our contract business is starting to see some momentum. And we’re seeing that not only in the medium business side but the large business side. Customer counts are strong in our retail business. Our SBD business continued to show some improvement during the quarter.

So I’m not sure its going to be a big time recovery but I think its going to be a slow steady recovery. Obviously there’s going to be some chops in the middle but I’m a little more optimistic than I’ve been maybe the last few quarters.

Operator

Your next question comes from the line of Brad Thomas – Kebanc Capital Markets

Brad Thomas – Kebanc Capital Markets

Wanted to just talk a little bit more about the margin expansion in North American delivery, it seems like a lot of things working well for you there, could you just talk a little bit more about how much of that is coming from Corporate Express and some of the levers that you’re pulling versus changes in the economic backdrop like the off contract sales coming back.

Ron Sargent

I would say its more what we’re doing. Obviously sales cured a lot of ills but I think we’ve done a really nice job of running our business better and tighter.

Joe Doody

I think its fair to say I’m very proud of the NAD team because we’ve obviously got a lot of activity going on in the integration. That’s yielding some good savings for us but at the same time it’s a lot of heavy lifting in the short-term, especially in the supply chain area, but it’s across the board in terms of good margin expansion, good benefits from sales force that we’ve seen and G&A, there’s just all areas of the business and as Ron said the off contract mix is improving.

That’s helping as well. And a little bit of volume growth as well.

Ron Sargent

And frankly the pretty tough quarter a year ago and just to be honest.

Brad Thomas – Kebanc Capital Markets

And then you had mentioned one of the elements helping you to drive expense leverage was lower marketing could you just talk a little bit more about your plans for marketing going forward and ability to continue to get leverage there.

John Mahoney

I think that one of the hallmarks of our entire marketing program is that its performance based. So we try and take a look at metrics like sales per marketing dollar and measure all of our programs on how productive they are. We test and we measure and programs that work we try and invest more in and programs that don’t we invest less in and that allows us to maintain a marketing spend that we think remains very productive and keeps us in the game and yet has the ability to maintain the same relationship to sales that it does historically.

And I think that’s true whether its one of our direct marketing businesses or whether its some of the things that we do in US retail that may be more branding for example with the TV programs.

Operator

Your next question comes from the line of David Strasser – Janney Montgomery

David Strasser – Janney Montgomery

I wanted to talk a little bit about gross margin in the retail business, you managed despite the higher mix in PCs to maintain a flat gross margin there, what were the offsetting factors to the negative mix that helped you there and do you think its sustainable going forward if that mix continues to go in that direction.

Ron Sargent

Demos is here, let me ask Demos to talk about some of his growth in the high margin business.

Demos Parneros

Well first of all on the low margin businesses like computers we are very focused on not only managing the inventory very carefully getting it out to the right stores at the right time and really just paying close attention to that so that we are selling the product earlier in the life cycle and not getting stuck with dated product.

But also in the stores really have focused a lot of effort a lot of energy on training our associates, really putting the right people on the floor at the right time and really selling a complete solution to the customer and doing a much better job with that than I think we’ve done in the past.

And as we’ve mentioned there are a lot of other highlights on the supply, the core supplies part of the business which we continue to pay a lot of attention to that’s the heritage core business and its important to us so I think we continue to work to innovate in store displays, try to create excitement in the store, really have good meaningful promotions that are going to drive both customer traffic into the store and also move some of the categories we mentioned.

Categories such as dated, business essentials, and of course ink and paper. So I think those have had a good impact on offsetting the core [inaudible]. And the last thing I should mention is our continued hard work on growing the services businesses both on the tech repair, EasyTech business as well as copy and print.

David Strasser – Janney Montgomery

As a follow-up to that when you do sell a full solution system to a consumer, how significant is the difference in margin versus the rest of the business. Can you get it relatively close when you’re on top of your game on the technology side.

Demos Parneros

I think we can. I think its challenging because we start out at a very low point and the idea is not to, it would be great to match the margin of the house but that’s probably not very realistic, so we just want to make every sale a meaningful one and I think taking time out to really listen to customers and do a very good job attaching the things they need, the software they need, anti virus, all of that makes a fairly meaningful difference.

It makes it worthwhile for us to pursue this.

David Strasser – Janney Montgomery

And the service business is at, are you kind of at your plan, above plan, and are you seeing it more as helping you sell other parts of the business or as a profit center on its own.

Demos Parneros

Tech business provides both actually, it’s a great business to have when selling a computer. Customers really need peace of mind and when they buy a PC its very important for them to meet our tech repair person whose right there and they gain the trust and confidence that if something should go wrong, they can come back to the store.

And then as a standalone business its got a very good profitable model so from a break fix or an upgrade cycle standpoint people can come in and get what they need with a fairly quick turnaround and its exciting that we now have trained associates in every single store throughout the US and Canada and continue to add more training to that.

So I think its continue to just keep getting better.

Operator

Your next question comes from the line of Kate McShane – Citi

Kate McShane – Citi

Can you give any additional commentary on the North American retail comps, you had mentioned that the comp reflected increased customer traffic but a lower average order size which is the opposite I think of what most companies have stated this quarter so any insight into exactly what’s driving traffic that may have improved quarter over quarter.

Demos Parneros

So we’re happy with the customer count increase of roughly 3%, that’s the good news. I think the one thing that we probably want a little bit different is for the composition of that number, that number was driven primarily by consumers and a little bit less of the small business customer. So though we’re getting the small business customer back we’re getting the consumer back faster.

I think a lot of our good promotions and incentives that we’ve put out there have really driven the traffic back to the store and I think a lot of the traditional non-office supply jobs related retailers have seen that increase over the past couple of months as they’ve reported in their numbers.

So I think that’s probably helps us get at why the number is higher and the AOV number is slightly lower so we continue to see tech prices go through their normal cycle of more features slightly less retail and we’ll just keep working on driving the traffic and building the average order.

So, not exactly the perfect mix but good and improving.

Kate McShane – Citi

And one last question, you definitely sounded more optimistic from when you last gave guidance in March, but guidance is basically remaining unchanged for the year, I guess its $0.02 a little higher on the lower end, so does this mean, I’m just trying to gauge how much of this is an effort to be conservative or does this mean that you haven’t seen much more of an improvement than when you first gave guidance in March for this year.

Ron Sargent

I’m not quite sure how to answer that question but am I bit more optimistic than I was last quarter? I am. I think we do want to be conservative in our guidance for the year. I think we’ve said that if things get better we’ll be at the high end. If things don’t continue in the direction they’re heading we could be somewhere in the middle.

So, I think we do want to be conservative. I’d much rather under promise and over deliver rather than the other way around but I think we have reflected the fact that our first quarter was pretty good. We’ve taken up the bottom side of the guidance by a couple of pennies and I hope to be able to do that every quarter this year.

John Mahoney

If I can just add to that, I think I mentioned that we do see a relatively slow rate of job growth in the economy overall which is going to be significant to us for us to be able to sustain faster revenue growth. So we’ve talked about low single-digit revenue growth throughout the year. If we see faster growth then that that would be positive but of the indicators we track we don’t see job growth as accelerating at a rate that would warrant extreme optimism about the back half of the year.

Ron Sargent

Kind of betting on the economy and its hard to do that.

Operator

Your next question comes from the line of Matthew Fassler – Goldman Sachs

Matthew Fassler – Goldman Sachs

Two questions, first of all you talked about the upcoming I guess the next state of the Corporate Express integration in the US which will really focus on supply chain can you talk about what you learned in Orlando and Kansas City, what you think the benefits to the cost structure and the working capital might be. Let me just ask the second question, get it out of the way, you gave us some interesting break outs of the composition of the international P&L speaking specifically about the delta in Europe, which exceeded the delta or the improvement that you saw overall in international, if you can talk about the other components of the international P&L and put those in context it would be very helpful.

Joe Doody

On the integration, as you noted we’ve got a couple of [quad] channel buildings under our belt in Kansas City, most recently Orlando has a few more scheduled here shortly this year. What we’ve learned, one is its not easy. They’re each a little bit unique because there are different local activities that have gone on in each of the buildings from Corporate Express standpoint that we have to take into account when we are bringing them on board.

So it’s a little bit more up front work in each and every one of them. So that’s what we’ve learned but as far as benefits that we’re achieving, both in terms of cost and inventory etc. is meeting the levels that we anticipated. So we continue to have a year of heavy lifting not only in terms of the integration of the quad channel buildings but also the many delivery hubs that we are in the process of integrating as well throughout the network, to get a single delivery geography consolidated between a Corporate Express suite and a Staples suite.

So, a lot of work being done throughout the rest of this year achieving the benefits that we anticipated and a little bit more upfront work than we anticipated going into each of the different markets.

Mike Miles

On the other components of the international P&L, the printing services division as I mentioned had a tough quarter. Their sales were down a little over 20% and that impacted our overall profitability by about 80 basis points. As I mentioned we’ve implemented significant headcount reductions in that business and sales have stabilized there so we expect that business to be profit neutral for the rest of the year which will be a nice upside over 2009’s losses.

China is the other big factor for us. As you know we lost about $50 million in Asia in 2009. We’re kind of in the three-step process of improving that. One is kind of back to basics, getting out of the unprofitable businesses we’re in and anniversarying some of the one-time costs and that’s going to kick in in the second and third quarters of this year. And then building the business, improving the gross margins there through better merchandising and ultimately building scale there. But for us in China Q1 was about the same as Q1 was a year ago.

The improvements that we expected there for the P&L will be more in the last three quarters of the year.

Matthew Fassler – Goldman Sachs

So given what you see currently from I guess printing in China in particular since that seems to be the biggest drag, at what point do you cycle the issues there and do they start to I guess together become neutral or perhaps even contribute year on year to the P&L.

Mike Miles

They should start to be positive at least in the year over year comparisons beginning in the second quarter.

Operator

Your next question comes from the line of Chris Horvers – JPMorgan

Chris Horvers – JPMorgan

Can you talk about the, I want to dig on the off contract purchasing behavior a bit more, some color on what you’re seeing there perhaps what the customers are buying compared to what they weren’t buying a year ago and if that was potentially maybe a flurry once those new budgets got, were put in place and it slowed down or are you seeing some encouraging consistency.

Joe Doody

Not a flurry, pretty much more consistent improvement there on a month over month, quarter over quarter basis. And we’re just seeing a little bit of relaxation on the part of some of our customers in terms of allowing people to buy the more discretionary products.

So an example of that would be our furniture business, is just slightly negative now. A year ago it was down between 20% and 30%, so, its not a built up demand, its been a pretty consistent improvement.

Chris Horvers – JPMorgan

Would you regard that furniture as the most discretionary portion on the off contract side.

Joe Doody

Its on a customers’ contract or its off. It varies by customers. So it depends on how the customer defines what’s on their contract and what’s not but certainly furniture is the one category that’s probably the most consistently off contract for a customer.

But it does vary by each and every customers’ definition.

Ron Sargent

Just to give you some numbers, the impact of that off contract on contract thing, a year ago Q1 of 2009, it was impacting our gross margin in NAD about 50 basis points negative, second quarter it was 30 points negative, third quarter it was 20 points negative, fourth quarter as we announced last quarter it was minus 10. And then this quarter plus 10.

So I think its kind of trend more than a blip.

Joe Doody

The only final point I’d make on it is that when you compare where we are this quarter versus a year ago as we said its an improvement versus two years ago first quarter of 2008, its still significantly lower.

Chris Horvers – JPMorgan

Is that on a two-year trend as we all like to look at it, is that improving.

Joe Doody

I don’t have that right in front of me so I can’t answer that for you.

Chris Horvers – JPMorgan

And then any commentary on what’s going on in the Quill business.

Joe Doody

Quill business is improving, so its gotten better as all of our businesses did on a trend basis. We like the trends there. Its an awareness building activity that we really need to drive with Quill. They’ve got a great brand, customers that pay service, they service better than anyone else. Extremely high customer satisfaction therefore extremely high retention.

Its all about acquisition, and there its about awareness. So those are the things we have to do to drive that business to positive comp growth.

Operator

Your next question comes from the line of Mitch Kaiser – Piper Jaffray

Mitch Kaiser – Piper Jaffray

I was hoping you could talk a little bit, I know you’ve made a lot of investments on the services side of the business in the EasyTech, can you just help us think about the expenses, as they ripple throughout the year and maybe some of the benefits, certainly they’ve shown up a little bit on the gross margin side as you talked about as you’ve expanded the tech.

John Mahoney

I think as we’ve talked about the investments we’re making, we talked about the fact that they tend to scale with results so whether its some of the remodels that we’re doing through copy and print and for our tech offerings in stores or whether its scale in labor in something like EasyTech or a sales force in copy and print, we’re able to pretty well scale those with the results.

So although it deleverages our expenses it isn’t an unmanaged deleverage in our P&L. So the scope of that really depends on the success we’ve had and as Demos described it we’ve had decent success in growing our businesses that we’re investing in faster than the rest of the house and through a combination of better execution and an improving economy we hope that that will continue and that will allow us to keep making those investments that will benefit the longer-term but not in a way that’s going to dramatically adversely impact the current year P&L.

Mitch Kaiser – Piper Jaffray

So the real benefit is in the utilization of the EasyTech I think, right, is that how to think about that.

John Mahoney

[inaudible] and I think that the issue is that we’ve tested this for some time in both the remodels we’re doing which improves our tech sales, the copy and print remodels that we’ve done which drives improvements in our copy and print sales growth, but they do scale. An EasyTech for example in a store doesn’t, isn’t as productive as a mature EasyTech when they first start and the same thing is true for many of the staff that we put in a copy and print center.

But we are able to see the productivity of each of those people grow in a way that although it requires some expense deleverage in the near-term we’re very confident that its going to result in driving that, the profitability of the store overall in the case of copy and print and the tech business and in some of the sales force changes we’ve made for the lines of business in NAD to improve and achieve some of our longer-term margin targets over time.

Mitch Kaiser – Piper Jaffray

And then could you just talk a little bit about your exposure in Europe to the government business. I probably should know that but if you could just maybe refresh us on that and maybe what you’re seeing there with the upcoming potential budget cuts.

Mike Miles

We don’t have a huge government business in Europe so I think we’re relatively limited to that particularly if you think about the countries in southern Europe that have been all grouped together as having real budget issues. We have not a lot of office products business there in general and not a lot of government business there.

We have a little more government business in Norway but I think their economy is on a much more solid footing.

Operator

Your next question comes from the line of Colin McGranahan – Sanford Bernstein

Colin McGranahan – Sanford Bernstein

First question just on SG&A, you highlighted marketing expense reduced marketing expenses the first driver in total and I think mentioned it in each of the divisions, can you talk about whether that’s a synergy saving, whether there’s some change in the marketing strategy or what’s driving the lower expense in the leverage on marketing there.

Ron Sargent

I think its probably two things, one it is the synergy savings because we’re obviously integrating our business and Corporate Express and there’s a lot of duplicative marketing costs that have gone away but I think the other things this evolution of marketing from Sunday circulars and catalogues to more of an online marketing which is a lot less expensive and frankly in most cases equally effective.

So I think its both of those things. I think its really kind of a marketing trend. I don’t think we’ve reduced our share of voice out there at all, in fact our customer count trends would indicate that we’re gaining share of customers but I do think both of those things are big impacts on our business.

Colin McGranahan – Sanford Bernstein

So you think that could be a little bit of a persist source of leverage going forward.

Ron Sargent

I think so.

Colin McGranahan – Sanford Bernstein

And then secondly just on the key growth initiatives, obviously it sounds like you had a little better promo business then what we’ve seen for quite some time, breakroom, how much of that do you think is just the, a little bit better improvement in the discretionary spending versus have you been able to measure the impact of say the new websites and the training hours that have started to trickle in for your contract sales force.

Joe Doody

First on the promo, I’ll tell you that is not really an increase, broad based due to more discretionary spending there. We achieved one major new bit of business in that area which heavily drove that growth that was indicated in the quarter. That was more of a one-time major bid win but broad based, in the promo area, is still seeing an increase due to company’s loosening up the purse strings if you will.

On the facility and breakroom as we said, we’ve seen our growth above the house there. That’s in dollars, in units its much higher than that because we’ve made some pricing moves to get us more as a destination category there and viewed as such, not a convenience category.

And we’re clearly ramping up on the sales force. A lot of cross selling activities going on. A lot of good early successes there but its still early. We are quite confident that that growth initiative is going to yield significant growth opportunities for us in the many, many years to come.

Colin McGranahan – Sanford Bernstein

We’re talking politics so handicapping odds is always a question but how confident are you that legislation will pass to return your tax rate back to the 34.5% range.

John Mahoney

You’re right, we have made a strong effort to avoid handicapping any politics. I can give you a couple of facts, the Bill that would extend these tax provisions has passed both the House and the Senate and is in reconciliation right now and there’s some reason to think that Congress has some sense of urgency about it.

We’ve got relatively arcane international tax allocation elements of the Bill, probably the one’s that has the most political clout is the R&D tax credit and you’ll notice some of the companies that are tech oriented have had similar bumps in their tax rate this quarter because they were unable to take the benefit of the R&D tax credit which is a stimulus.

So, I guess without handicapping it the facts would dictate that it would surprise us if it didn’t pass some time during the year.

Colin McGranahan – Sanford Bernstein

And how is your cash tax rate comparing to your accrual tax rate at this point.

John Mahoney

Our cash tax rate is only slightly lower than the accrual tax rate. We don’t have a huge number of timing differences.

Operator

Your next question comes from the line of Michael Lasser – Barclays Capital

Michael Lasser – Barclays Capital

Turning back to an earlier discussion aside from the currency impact are you seeing any change in as you look at present trends in the rhythm of the business in Europe are you seeing any change from the events and would you expect that to be an immediate impact or might it take a little time for it to trickle through to have an impact which will maybe slow down some of the results there.

Mike Miles

We’ve had a nice gradual improvement in most of our European businesses over the last nine months. It has been though over that period of time relatively choppy as its come back and so I don’t want to try and read too much into numbers one way or the other over the last few weeks since this, the Greek crisis has unfolded.

As I said earlier I think our story in Europe this year is more one of margin improvement as opposed to betting on a huge economic recovery so absent something catastrophic I think we’re in pretty good shape for our plans for Europe this year.

Michael Lasser – Barclays Capital

And then in the US business are you noticing any changes in the competitive pricing environment and do you anticipate as conditions continue to improve that this could put some, it could become a bit more intense, more so on the delivery side than the retail side.

Joe Doody

I think the market is always very competitive but it continues to remain rational. We continue to utilize our low cost model to build sustainable profitable growth and we’re extremely satisfied with the level of acquisition and retention that we’re currently experiencing out there.

Our margin expansion, I think that you’re seeing in our strong profit margin rates I think is indicative of our continued pricing discipline as well as the use of our low cost structure. So we continue to be disciplined and going after new business and as well as all of our existing business, it’s a competitive marketplace, we anticipate that that’s going to continue.

Michael Lasser – Barclays Capital

How did your public sector business do during the first quarter.

Joe Doody

Its done great. To be honest the sales at government is not a significant part of our existing business but we have certainly seen increased opportunity and willingness of states and municipalities to not just enter into a dialogue but to pursue business with us. We are investing and growing our sales force in that area and have been doing that.

We continue to gain momentum there. So its growing very nicely. We’re extremely satisfied with that business.

Operator

Your next question comes from the line of Mike Baker – Deutsche Bank

Mike Baker – Deutsche Bank

A couple related questions, and back to Europe so your full year sales guidance is the same at low single-digits but have you changed what you think about in terms of reducing your expectations for Europe given what’s going on there and I guess related question is maybe you can talk a little bit more detailed in terms of the trends in Europe since this Greek thing has started to unfold over the last couple of weeks, has business fall off at all in Europe and I guess while we’re talking about trends if you could just talk about the trends in the US through the quarter, that would also be helpful.

Mike Miles

I think, as we look at Europe and think about the full year and for us to achieve the guidance that we’ve got and our plans, kind of the key thing that needs to happen and we’re really looking at it as kind of our issue as opposed to the market, the key thing that has to happen is we need to get our retail comps going again.

As I mentioned we made progress in most of the markets in Europe. The Netherlands was the one exception to that but Germany and Portugal and the UK were all at least as good as Q4 and in most cases stronger than we saw during 2009 and during Q4 so we’re seeing a recovery.

As I said before I don’t want to talk too much about the last couple of weeks in Europe because over the course of the last year its been very choppy and I wouldn’t want to read anything into the numbers that we’re seeing week to week there.

But for us turning the comps around which I think is about getting as I said the business customer buying office supplies from us that’s the key challenge for us with European sales.

Ron Sargent

And I think John tried to address the currency issue, we do probably have a stronger currency in places like Canada and Australia in the event we’ll see lower currency in Europe. In terms of last quarter I think we’ve said the business was a little choppy but April was our best comping quarter, or comping period in our retail business. So we saw some good success in April.

Mike Baker – Deutsche Bank

If I just follow-up one more time just more specifically again your total sales number is low single-digits, the same as it was, I imagine you build that up US delivery international, have the components of that low single-digit guidance changed today versus when you talked about that guidance in the fourth quarter.

Ron Sargent

I don’t think so, its probably a level of precision that, I’m not perfectly able to answer but I think in general we feel kind of similarly about the growth trajectories of each of our three businesses as we did three months ago.

Operator

Your next question comes from the line of Dan Binder – Jefferies

Dan Binder – Jefferies

Just a question on your ability to get the average order size up, particularly in Corporate Express, I was wondering if you could give us an update on where that gap is today and the progress you’ve been able to make.

Joe Doody

There’s still a gap there but the business is becoming so integrated we’re really looking at our overall combined Staples and Corporate Express results to track our improvement, so, we’re not just looking at improving the former CE base but also always looking to drive the Staples base as well.

So we’re around $200.00 combined, it was up about $7.00. We had several hundred basis points improvement and reduction of our small orders. So it is something that our sales team in contract is driving on an every day basis in their workings with our customers.

And providing incentives to them as well as incentives to our customers to drive that behavior. And we’re extremely satisfied, it’s a slow and steady improvement.

Dan Binder – Jefferies

And then a follow-up on the Corporate Express side of it, recognizing you’ve had it for a while now and maybe a little bit harder to discern the difference, just curious, are we now through sort of that period where there’s an attrition from the change. I’m sure you had probably built something at the outset for some attrition of those accounts, just curious if there’s still any pressure there.

Joe Doody

Well pressure there is to perform many changes to the customers pretty flawlessly. So, we talked about the fact that we’re making infrastructure changes out there, closing down buildings, consolidated volume into different buildings. We’ve got to pull that off flawlessly so that its not seen by the customers.

If we don’t then there’s certainly risk, not only to our CE customers but to our Staples legacy customers. So we’re going to continue to go through more changes for our customers. Our delivery drivers will change for most of our customers as we consolidate suites together and geographies.

So we’ve got to do everything we can to minimize that disruption to the customer. We also mentioned the fact that we’re working on a new ecommerce site that will be used for both our Staples legacy and our CE customers. Converting customers to that site when that becomes available is another change and again, we’ve got to just pull those all off flawlessly.

But so far I think we are extremely satisfied as I said with our level of retention not only among our existing Staples legacy customers but also our former CE customers.

Operator

Your next question comes from the line of Joe Feldman – Telsey Advisory Group

Joe Feldman – Telsey Advisory Group

One question was any commentary on the regional trends here in the US and what you’re seeing.

Ron Sargent

We’re really seeing broad based kind of improvement across the country and across all regions. We sliced it and diced it but there’s really not much difference throughout the country.

Joe Feldman – Telsey Advisory Group

And then just another follow-up on Europe how much of the weakness that you’ve experienced I guess at least in this quarter and as of late just relates do you think to sort of rebuilding that brand especially as you put together the Corporate Express with Staples versus the macro pressure that is obviously happening over there.

Mike Miles

I think its virtually all the macro pressure. I don’t think we’re suffering anything for the transition of the brand from Corporate Express to Staples. In fact in Norway small geography limited number of stores, but we changed all the stores there from the banner [Endures] which was what they were called under Corporate Express to Staples in the first quarter and we had 3% comp sales growth there which was by far the best performance we had in our European retail.

We’re in most cases Corporate Express didn’t have a great strong brand in Europe so the change has been relatively a non-event from most customers. There are a few Staples legacy brands in Europe like JPG and [Mondoffice] in the catalogue space that do have very strong brand names and heritage and we’re going to be more gradual about our transition there.

So I think most of the issues that we’ve seen in Europe have been economic and hopefully as the economy recovers so will our sales.

Joe Feldman – Telsey Advisory Group

One more follow-up on the gross margin obviously was pretty solid this quarter and I understand what the drivers are and we were just kind of thinking of those drivers what do you think is sustainable going forward. I would bet that its still early innings in terms of the synergies that you’re realizing and the buying power, but if you could maybe talk about that a little bit more.

John Mahoney

I think that in each of the businesses they’ve got their own margin characteristics. In international for example we talked about the buying synergies coming in later then they had in the US and so that’s one of the big drivers in Europe. In NAD the improvements we’ve seen over the last 18 months in distribution and delivery has had a dramatic impact. We’ve seen some pressure more recently with some of the elements of transportation.

But overall NAD through a combination of getting the average order size up in the contract business, driving the mix in SBG, and getting the order size up at Quill all have driven gross margin there and all of those things are sustainable.

In North American retail, probably the biggest issue there is mix and Demos talked about driving improvements, faster growth in some of the high margin service businesses, improving attachment rate in the tech business all helped. So each of them has their own story but it isn’t one dimensional in any of the business units.

Each of them have a number of initiatives they’re working on all of which should allow us to continue to see gross margin improvement.

Operator

Your next question comes from the line of William Truelove – UBS

William Truelove – UBS

I was hoping you could talk a little bit about the strong customer acquisition in North American delivery, is it coming from new businesses, are you acquiring customers from the independents or from say the other big box retailers in that area.

Joe Doody

All of the above. I think its clearly its both mid volume, mid market as well as some large customer base. You’ve got all situations where you’ve got customers in some cases limited but still some that are consolidating programs for the first time. Others that its just a competitive win in the marketplace so it really comes in all sizes and flavors.

Ron Sargent

Just to give you a little color commentary in the first quarter our sales from existing accounts were kind of flattish from last quarter, our lost accounts went way down, our sales from new customers went up and our line of business customers also went up. So just kind of gives you a sense for what made up the number.

Operator

Your next question comes from the line of Alan Rifkin – Bank of America

Alan Rifkin – Bank of America

I think in hindsight we can certainly see your reason for caution in terms of greater share buybacks on the prior conference call, now that we’ve been able to quantify the incremental investment in Australia and you said that you are looking for stronger cash flow in the second half, can you maybe just shed a little bit more color on, and realizing that obviously the environment is still difficult but could you maybe just shed a little bit more color on the hesitancy at this point to commit to some share buybacks throughout the remainder of the year if your cash flow does continue to improve.

Ron Sargent

I don’t think we’re hesitant at all, I think, first of all its not my decision, its our Board’s direction that will determine whether we do buybacks or not but we wanted to make an investment in Australia and I think we’ve allotted money to do that. We’ve wanted to obviously do the inventory build for back to school, and that’s really the story in the second quarter and you’re right, in the third and fourth quarter we hope and expect that cash flows are going to be stronger and I think at that point we’d be willing to consider buying back stock.

I think we already have an authorization out there. I think we’ve probably got close to a billion dollars left in the pre existing authorization so, no, I don’t think its an unreasonable question and I think its one that our Board will consider at our next meeting.

Alan Rifkin – Bank of America

Just a follow-up if I may, hypothetically if the cash flows do come in over and above your plan for the year would it be reasonable to expect that the incremental cash flow would be used for share buyback as opposed to further incremental investment.

Ron Sargent

I hate dealing with hypothetical’s, so its hard for me to kind of give you a, kind of a sound bite that kind of commits us to anything at this point.

Operator

Your final question comes from the line of Stephen Chick - FBR

Stephen Chick - FBR

Just two questions and the first is related or another question on North American delivery margins and if I look at it it was very good quarter, it looks like operating earnings in that segment were up $43 million year over year really at close to the level of sales. And so on an incremental basis its nearly 100%. It sounds like margins were up in the delivery business and I know there’s some synergies, how as we look forward can you speak a little bit to what the say fixed versus variable costs are for North American delivery, and how we can think about incremental margin and margin expansion as we head through the rest of the year here.

John

Maybe I’ll just comment first and then Joe can pitch in afterwards, our expenses change in terms of whether they’re fixed or variable depending on within our planning ranges so there are a lot of moving parts in a big business like Joe’s that drive the flow through. Obviously we don’t expect to see 100% flow through on sales dollars going forward.

Ron mentioned that we had a relatively easy compare in NAD with last year’s first quarter in terms of the operating margin rate but I think we’re looking for over the long-term steady improvement in the operating margin of NAD towards our long-term target and we’re not going to see that in a linear fashion exactly the same rate every quarter.

Joe Doody

And thank you noticing that contribution in the quarter, but as John said I think we’ve got a lot of activities that are driving to achieve our long-term goal and we’re not going to see that type of quarterly improvement consistently moving out there but we are driving long-term towards that 10% operating profit and its thing from the supply chain efficiencies, from our integration, its continued own brand penetration.

Obviously recovery in our higher margin categories, improvement in sales to existing customers which are still down, that’s in our core categories and then the growth initiatives especially the [inaudible] but also furniture, promotional products, and tech and copy and print that are going to drive the top line to really generate long-term margin growth that we’ve committed to out there.

So I hope that helps.

Stephen Chick - FBR

And then second if I could, I know we’re tight for time here, so for operating and selling or actually SG&A costs for the quarter they grew at about a 45% rate to sale growth so it was a very good quarter for costs and you talked about the lower marketing expenses, what kind of, can you speak to how we should think about that rate of SG&A growth going forward. Are the lower marketing expenses sticking up where we should see that level of SG&A growth relative to sales or would you expect that to creep up for the rest of the year.

John Mahoney

The key really is the investments we’ve made in our growth initiatives and as I mentioned earlier we try and make those investments at a pace that allows us to maintain reasonable improvement in operating margin but at the same time drive sales growth in all of those categories. So it may not be linear I guess as we go through the year but I mentioned marketing expenses all about measuring the productivity of the marketing tools we use.

I would expect to see improvement there. Our G&A expenses have been very tightly managed and expect to see improvement there as well. So I think you can expect us to sustain operating margin improvement throughout the year.

Stephen Chick - FBR

And did you say that for guidance you’re expecting a 37.5% tax rate in guidance, did I hear that right.

John Mahoney

For the second quarter yes, for the year as a whole we’re anticipating assuming Congress passes this extension provision in the law that it will return to 34.5% for the year.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Ron Sargent

Thanks everybody, realize we’re running a little late but thanks for joining us on the call this morning. We look forward to speaking with all of you again very soon.

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