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Office Depot, Inc. (NYSE:ODP)

Q1 2014 Results Earnings Conference Call

May 6, 2014 9:00 AM ET

Executives

Michael Steele - Vice President, Investor Relations,

Roland Smith - Chairman and CEO

Steve Hare - Executive Vice President and CFO

Analysts

Brad Thomas - KeyBanc Capital Markets

Mike Baker - Deutsche Bank

Matthew Fassler - Goldman Sachs

Greg Melich - ISI Group

Michael Lasser - UBS

Dan Binder - Jefferies

Operator

Good morning. And welcome to Office Depot’s First Quarter 2014 Earnings Conference Call. All lines will be in a listen-only mode for today’s presentation. After which instructions will be given in order to ask a question. At the request of Office Depot today’s call is being recorded.

I would like to introduce Vice President of Investor Relations, Michael Steele. Mr. Steele, you may now begin.

Michael Steele

Good morning and thank you for joining us today. Here with me are Roland Smith, our Chairman and Chief Executive Officer; and Steve Hare, our Executive Vice President and Chief Financial Officer.

Please keep in mind that certain statements made on this call include forward-looking statements, which are subject to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements reflect the company's current expectations concerning future events and are subject to a number of factors and uncertainties that could cause actual results to differ materially. A detailed discussion of these factors and uncertainties is contained in the company's filings with the Securities and Exchange Commission.

This call includes non-GAAP financial measures, the SEC filings, as well as the earnings press release, presentation slides that accompany today’s comments, reconciliations of the non-GAAP financial measures to the most directly comparable GAAP financial measures, as well as 2013 pro forma results for combined Office Depot and OfficeMax which were furnished to the SEC on Form 8-K on March 21st are all available on our website at investor.officedepot.com.

Today's call will begin with Roland summarizing the quarter and providing an update on select critical priorities for 2014 and our progress on the merger integration. Steve will then review the company's quarterly results and outlook for 2014. Following Steve's discussion, Roland will share closing comments and then we'll open up the line for questions.

Now I'll turn the call over to Roland.

Roland Smith

Thank, Mike, and good morning, everyone. It's good to be here today to discuss the first quarter of 2014, our first full quarter as a merged company. I'm very pleased with our performance for the quarter.

In the past five months, we’ve made significant progress with our merger integration. We selected our headquarters, named our leadership team, restructured the organization, validated and begin executing our plan to realize merger cost synergies, completed a preliminary analysis of our retail store portfolio and have made good progress with our other critical priorities. I'm very proud of our team's ability to accomplish so much so quickly.

Turning to slide four, in the first quarter of 2014, we saw improved sales trends as the quarter progressed and I'm especially encouraged by our ability to reduce overall expenses.

Adjusted operating income improved by 33% to $72 million in the first quarter of 2014 versus pro forma Q1 2013. While weather was a challenge to our business early in the quarter, we saw improvement in sales trends as the quarter progressed. Additionally, we captured merger integration benefits earlier than planned.

Our positive first quarter results have increased our confidence and our ability to improve profitability and achieved merger synergies. Accordingly, we are raising our 2014 adjusted operating income outlook to be not less than $160 million for the full year.

On our last call, I noted that one of our critical priorities was to construct a plan to optimize our retail store portfolio and I mentioned that we expected to complete our analysis in the second quarter. We remained on track with that timing. But I'm very pleased to be able to share details of our preliminary analysis with you today.

Based on this preliminary work, we expect to close at least 400 stores by the end of 2016, 150 of which would close by the end of 2014. We anticipate that by the end of 2016, the optimization of our retail store portfolio will generate additional annual run-rate synergies of at least $75 million, in addition to our previously announced $600 million of cost synergies and will be accretive to earnings beginning in 2015. I will provide more details on store closures later on this call.

As you know, in February, we introduced our 2014 critical priorities. Shown on slide five, these are priorities that will enable us to deliver our annual operating plan and transform Office Depot.

On today's call and future calls, I’ll provide a progress update on selected priorities. Today, I'd like to update you on our culture in organization, our plan to optimize our retail store portfolio, our progress on synergies and efficiencies, and the development of our unique selling proposition. Later on the call, Steve Hare, will update you on our initiatives to improve profit margins.

As you may remember, we have two foundational priorities for 2014, a lean and effective organization and a high-performance culture, and we are making excellent progress on both.

Our restructured organization is significantly smaller and more efficient. The new structure facilitates better decision-making, enhanced accountability and better communication. These are all key attributes of a high-performance culture. During the first quarter, we continue to enhance our management team with the addition of several strategic hires, which are highlighted on slide six.

In March, we announced that Juliet Johansson join Office Depot as Executive Vice President and Chief Strategy Officer. Juliet’s background includes a decade of strategic consulting experience, including eight years with McKinsey & Co. where she advised senior executives and recommended strategies in a variety of industries, including retail, consumer products, fast food and high technology.

She also held senior executive roles in strategy, national sales and marketing with global transportation provider Ryder System. Juliet poses the ideal mix of advisory talent and practical experience needed to develop the strategies and initiatives that will drive future growth.

In early April, Petter Knutrud joined the team as a Senior Vice President for Merchandising. Petter has more than 25 years of experience in all aspects of merchandising spending the past 19 years with Staples and most recently serving as SVP, Merchandising Supplies.

He created new and exclusive product lines in multiple categories to improve differentiation and drive sales growth across channels. As a member of merchandising leadership team, Petter will be instrumental in helping to set and refine merchandising strategy and direction for Office Depot.

In mid April, we also welcomed Troy Rice as Executive Vice President of Retail. Troy has extensive multiunit retail experience having served 24 years growing revenue, improving operations and increasing profits for two leading retail chains.

He most recently served for eight years as Executive Vice President, Stores and Services at Toys “R” Us. Previously, Troy spent 16 years at the Home Depot in retail leadership roles of increasing responsibility. I am confident that Troy’s depth and breath of retail experience will bring great value to Office Depot at a time when we are making significant structural improvements to our retail store network.

Now, I would like to update you on our retail store portfolio. As I mentioned last quarter, we engaged Bain Consulting to help us conduct a comprehensive analysis of our retail store portfolio.

Our store specific decisions are being made through a holistic market evaluation process. This process includes a three-stage approach, focused on optimizing, productivity and profitability, which we layout on slide eight.

The initial stage is to identify the optimal portfolio to improve retail profitability. We are currently working on this analysis with a market-by-market and store-by-store evaluation looking at six key factors that include, store performance, sales transfer rate, the impact of fixed costs on the remaining stores, store closing costs, including lease obligations, expected impacts to other sales channels and our overall go-to-market strategy.

As we identify stores to be closed, we will sequence our closures to maximize the economics. As I mentioned earlier, our goal is to finalize our store optimization strategy in the second quarter and we will update you on our progress on future calls.

The second stage of our approach is to maximize the profitability of the ongoing retail store portfolio. We will leverage our larger combined market presence to negotiate more favorable lease terms and continuously monitor performance of store locations, particularly approaching lease expirations.

The final stage is to define and implement our store of the future. This will require experimentation and testing in order to achieve the right product and service mix. But it's critical to our long-term success, particularly given the evolution in our industry and the changes in how customers shop. Our store of the future will closely align with our unique selling proposition and I’ll update you on this in a few minutes.

We believe a staged approach to store closures allows us to minimize risk and adapt our learnings to future groups of store closings. Our continues assessment of transfer rates, lease costs, stranded costs, et cetera, is informing our decisions to close and our closure cadence, an important focus will be maintaining relationships with our valued customers, who shop in the stores that are slated to close. We will provide continuity and direction to encourage these customers to continue to purchase from us at a nearby store or online.

As highlighted on slide nine, based on our preliminary analysis, we expect to close at least 400 stores by the end of 2016, with 150 of those stores expected to close in 2014. Most of these 150 stores will remain open through the important back-to-school selling season this fall. We expect to close at least 250 stores over the 2015 to 2016 timeframe. As we continue our review, we will determine working capital savings and closing costs.

Additionally, we’ve made the decision to close all 19 Grand & Toy stores in Canada. These stores represent only 3% of our Canadian sales and we believe we can serve our customers in Canada much more efficiently through our e-commerce website, field and telephone sales representatives and customer service centers.

Finally, we are in negotiations with our Mexican joint venture partners to sell our 51% interest in Grupo OfficeMax, which consist of 92 OfficeMax branded retail stores. We expect this transaction to close in the second quarter.

Now I’d like to provide you an update on the status of achieving our planned synergies. As I have already stated, during the first quarter we accelerated the realization of cost synergies, thereby giving us greater confidence in our ability to meet our longer term targets.

Turning to slide 11, after the preliminary analysis of our U.S. retail store portfolio optimization, we are increasing our expected annual run-rate synergies to more than $675 million by the end of 2016. This is an increase from the company's previous estimate of more than $600 million prior to the preliminary review of our U.S. retail store network.

In addition to the at least $75 million of synergies from store optimization, we continue to expect purchasing synergies of approximately $130 million and more than $470 million of additional annualized savings primarily in SG&A.

In our 2014 P&L, we expect to realize approximately $180 million of synergies up from the $170 million we communicated on our last call, of the estimated $180 million this year, we realized approximately $14 million of synergies in the first quarter.

We expect synergies to accelerate throughout the year and in the year at an annual run-rate of approximately $360 million, which is an increase from the $340 million we communicated last quarter. This excludes any benefit from the retail store portfolio optimization.

Now, I’d like to discuss progress on our unique selling proposition. As I shared with you on our last call, the foundation of our successful long-term growth strategy is a meaningful unique selling proposition or USP. A clear and meaningful USP will enable us to truly differentiate ourselves from our competitors and drive our branding, product assortment, new product and service selection, and how we go to market.

As you can see on slide 13, our USP development and implementation is a three-part process. First, defining the, who, that is who we’re going to serve in the market place, who we see as profitable customer segment and who we need to target for growth.

Second, defining the what. What unique and differentiated proposition across price, product offering and customer experience will motivate these segment to increase their total spend with Office Depot. And finally defining the how; how we will redefine our business channels products and services to fully deliver this unique proposition. This stage includes in-market testing to validate the concept and optimize USP execution before rolling out more broadly.

We are making excellent progress and are on track to define and begin testing our USP in the third quarter. And I'll provide you a more detailed update on our next call.

Now I’ll turn the call over to our CFO, Steve Hare, to discuss our results for the quarter and outlook for 2014. Steve?

Steve Hare

Thanks Roland. I would like to highlight our results for the first quarter, which demonstrated significant expense improvement in each of our business divisions as well at the corporate level. The prior year comparisons that I will focus on today will be versus combined pro forma results which we believe provide a more relevant measurement of our ongoing operations.

The pro formas for Q1 2013 assumed the merger occurred at the beginning of 2013 and included adjustments for purchase accounting, charges and reclassifications. Now, looking at consolidated results on Slide 15, first quarter 2014 sales were $4.4 billion, down 3% from the prior year quarter on a pro forma basis.

We believe weather had a significant negative impact on sales early in the quarter. Gross profit decreased $61 million from the prior year pro forma and gross margin was down 68 basis points. We experienced gross margin declines in each division with the more significant decline in business solutions.

SG&A expenses in first quarter 2014 were $79 million lower than prior year pro forma representing a 114 basis point reduction as a percentage of sales. The first quarter reported or GAAP operating loss included pretax special charges totaling $151 million.

The charges were comprised of $96 million in merger-related expenses, which included employee severance, retention transaction and integration expenses, $41 million in non-cash impairment charges related to IT system write-offs, $9 million in non-cash U.S. store impairment charges and $5 million in international restructuring and other operating expenses. The tax benefit of these pretax charges was $4 million.

Excluding these special items, first quarter adjusted operating income was $72 million and the adjusted net income attributable to common stockholders was $38 million or $0.07 per share. The first quarter 2014 adjusted operating income was 33% improvement over the prior year pro forma and adjusted net income this quarter was over 100% higher than the prior year pro forma.

These improvements were largely attributable to SG&A reductions, including $14 million in merger cost synergies and improving execution on day-to-day operations in each division. The expense reduction efforts more than offset the sales deleverage impact of the lower sales versus the prior year pro forma.

Turning to Slide 16. First quarter 2014 sales in North American retail decreased 5% versus the prior year pro forma. Same-store sales for the combined Office Depot and OfficeMax stores declined 3%. The comp sales decline was driven by lower transaction counts partially offset by higher average order values.

We experienced sales declines in supplies, furniture and technology related products while sales increased in copy and print. Adverse weather in the first part of the quarter had a negative impact on comps for the combined company.

The retail division generated $37 million in operating income in the first quarter, which was a 19% improvement over the prior year pro forma. The division operating margin improved by 44 basis points. Deleveraging due to lower sales was more than offset by lower operating expenses including payroll, advertising and other in-store expenses in both Office Depot and OfficeMax retail stores.

On the Slide 17, earlier Roland mentioned our focus on 12 critical priorities in 2014. I would like to provide you a little bit of color on some of the key initiatives that each division is focused on to improve profit margins. In North American retail, the realignment of the field leadership team which was completed in the first quarter of 2014 was a significant step toward realizing ongoing merger synergies and creating a foundation for future profit building initiatives.

In addition to reducing the number of combined company regions and district and increasing span of control throughout the division, the process allowed senior management to select the best talent from both organizations. This leadership team will be focused in 2014 on creating a consistent operating model for retail operations in both Office Depot and OfficeMax retail stores.

Components include an optimized staffing and labor model and enhanced selling model, a streamlined logistics process, divisionwide key performance indicators and standardized reporting as well as developing consistent bonus and incentive plans all to drive results. Another significant initiative for the North American retail division this year will be to support and execute the retail store portfolio optimization effort that Roland spoke about. The retail teams will be focused on maximizing sales transfer, selecting the best talent going forward and ensuring that customers of both brands continue to have a great shopping experience.

Turning now to Slide 18. In the first quarter results in our business solutions division or BSD, first quarter 2014 sales in BSD were $1.5 billion, a decrease of 2% from the prior year quarter pro forma sales. Sales in the contract channel within BSD were down low single digits and direct channel sales were up slightly.

Adverse weather in the early part of the quarter had a negative impact on contract sales. Many workplaces including schools and government offices were closed during the periods of extreme weather and customers therefore did not order products or consume office supplies. Sales in the contract channel were also negatively impacted by the currency exchange rates in our Canadian business and the New Year's calendar shift, partially offset by the positive impact of an Easter calendar shift.

Excluding these factors, sales for the quarter in the contract channel would have been flat for the quarter. In the direct channel, online sales increased and call center sales decreased, continuing the trend that we've been seeing for some time. We continue to enhance the online shopping product offering and customer experience.

On a product category basis within BSD, sales of supplies and technology items in the first quarter were lower than the prior year pro forma while sales of furniture, copy and print, and cleaning and breakroom increased.

BSD gross margin declined in the first quarter of 2014 compared to combined pro forma results in the prior year quarter, driven in large part by a greater mix of lower margin enterprise customers in the consolidated portfolio.

The leadership team in contract is focused on harmonizing the sales strategies between the legacy brands to improve our overall customer mix and to retain and win business that meets our margin objectives.

The BSD division operating income for the first quarter of 2014 was $40 million, an increase of 5% versus pro forma in the prior year quarter. Division operating margin improved by 17 basis points. Lower payroll, which included sales force synergies, lower advertising expense, and other SG&A efficiencies more than offset the flow-through impact of lower sales.

On slide 19, we outlined a few of the key initiatives that our BSD Contract and Direct channel teams are working on this year to improve profit margins. To optimize margin potential, we are harmonizing Contract sales strategies between the Office Depot and OfficeMax brands through the alignment of pricing, assortment and incentive strategies. The Contract teams are focused on expanding sales into more profitable customer segments and also increasing sales in adjacencies, such as cleaning and breakroom.

In the Direct channel, we are leveraging our resources and investments across brands to improve our web platform. Our teams are improving website and mobile app usability and selling features making even easier for customers to find products, check out and manage their account and preferences. We are also building personalized product recommendations. Additionally, we are optimizing our digital marketing and promotional programs to improve customer acquisition and retention while lowering cost by leveraging efficiencies across both Office Depot and OfficeMax banners.

On slide 20, I will cover the first quarter results in the International division. For international sales comparisons to combine prior year pro forma results by channel, I will use constant currency. First quarter 2014 sales in the International division decreased 1% in constant currencies versus the combined prior year quarter pro forma results. Sales in the Contract and Direct channels in Europe both declined in the quarter and sales in the retail channel increased from the prior year quarter. The timing of the Easter holiday had a positive impact on European sales in the first quarter when comparing 2014 to pro forma 2013.

First quarter 2014 division operating income was $20 million, an increase of 18% versus pro forma in the prior year quarter. Division operating margin improved by 34 basis points. The division experienced gross margin pressure in the quarter largely due to higher than expected supply chain cost. Significant reductions in operating expenses, including reduced payroll and advertising expense, offset the negative flow-through impact of lower sales and lower gross margins. The International division continues to focus on increasing efficiencies and reducing costs.

As Roland mentioned, we are currently in negotiations with our joint venture partners to sell our interest in the Grupo OfficeMax business in Mexico. The assets and liabilities of the joint venture have been classified as held for sale on our balance sheet at the end of the first quarter. Sales and expenses of the joint venture will be included in our International division operating results through the date of sale, which we expect to occur sometime during the second quarter.

Now let me review a few of the key initiatives in the International division that target improved profit margins. In Europe, we are changing the division’s operating model to shift from a country specific or regional focus to a channel focus, which is expected to reduce redundancies and provide greater opportunities for top line growth. The operating model change will be a catalyst for moving to a lower cost to serve model. Plans to increase gross margin include expansion of private brands, broadening the utilization of customer profitability tools to eliminate unprofitable accounts, identify new account opportunities, improve bid decision and optimize the mix of outsource versus private fleet transportation. Sales force effectiveness will be increased through a combination of factors, including improved compensation plans, sales training, adjustments to customer coverage models and leveraging best practices across the regions. Components of the online initiative include investing in additional online advertising funded through catalog efficiencies, personalization, and optimizing product search as well as checkout and payment functions.

Turning to the balance sheet highlights on slide 22, we ended the first quarter of 2014 with total liquidity of approximately $2 billion, consisting of $870 million in cash and $1.1 billion available under our asset-based lending facility. Total debt at the end of the quarter was $720 million, excluding $854 million of non-recourse debt related to the legacy OfficeMax Timber Notes securitization transaction. Office Depot used $74 million of operating cash in the first quarter of 2014, which included $80 million in merger-related cash payments. Capital expenditures were $39 million. We expect free cash flow to be negative this year as we continue to incur significant merger integration expenses in the short term that will lead to a more profitable and efficient organization over the long term.

In the first quarter of 2014, we received a distribution of 1.6 million shares of Boise Cascade Company common stock related to a legacy OfficeMax equity investment in Boise Cascade Holdings. We sold 785,000 shares during the quarter, with proceeds totaling $22 million. The market value of the remaining shares at the end of the first quarter was $20 million. We expect to liquidate all of these securities this year.

Turning to our 2014 outlook on slide 23, we continue to expect market trends will remain challenging and anticipate total company sales in 2014 to be lower than the prior year combined pro forma sales. As we have noted, we improved profitability during the first quarter with earlier than expected realization of cost synergies and improved operational execution. Accordingly, we are increasing our adjusted operating income outlook for the full year to not less than $160 million. That said, we are now in the second quarter, which historically has been our lowest sales volume quarter of the year, and therefore, it’s more difficult to drive profitability. As a reminder, we had an adjusted operating loss in Q2 of last year on a pro forma basis.

On the cost side; to achieve the more than $675 million in expected merger run rate synergies, we continue to estimate that $400 million of cash integration costs will be required to substantially complete the integration, with approximately $300 million of those expenses incurred in 2014. This expense estimates exclude cost relating to optimizing the U.S. retail stores, which have not been determined. Capital spending to complete the integration is expected to be between $200 million and $250 million over the 2014 through 2016 period, with up to $50 million of that spend expected in 2014.

Excluding capital spend related to the merger, we expect capital expenditures for the core business to be approximately $150 million this year. Depreciation and amortization in 2014 is expected to be approximately $300 million.

That covers the financial results for the quarter. We are pleased with our progress and with much work ahead, continued to focus the teams on integration, cost control and improving operating margins.

Now, I will turn it back over to Roland for closing comments.

Rolland Smith

Thanks, Steve. As you can see on Slide 24, our path to transformation begin in November as we focused on restructuring into a leaner more efficient organization. As I noted earlier, we’ve made significant progress in our integration transformation over the past five months.

We selected our headquarters, named our leadership team, restructured the organization validated and begin executing our plan to realize merger cost synergies, completed a preliminary analysis of our retail store portfolio and have made good progress with our other critical priorities.

We certainly have a lot of work ahead of us. But I’m very pleased with the team’s energy, morale and optimism. I’m also very proud of how quickly our associates transformed from being competitors to a unified team, working in harmony towards common goals.

The increase in our 2014 adjusted operating income outlook to not less than $160 million reflects the improving sales trends we expect as the first quarter progressed, our ongoing focus on expense control and our improved realization of synergies and efficiencies. As we continue our integration across all areas of the company, we are beginning to take step towards the next phases of our transformation, sales and margins stabilization and pursuing long-term profitable growth opportunities.

Thank you for your attention this morning. Now, I will turn the call over to Mike.

Michael Steele

We’ve reserved the balance of the hour for Q&A. We ask you to limit yourself to one question, so we can get to as many of you as possible. Operator, please open the line for questions.

Question-and-Answer Session

Operator

Certainly. (Operator Instructions) And our first question comes from the line of Brad Thomas.

Brad Thomas - KeyBanc Capital Markets

Thanks. Good morning and congratulations on all the progress and a good quarter here.

Speaker

Thanks Brad.

Brad Thomas - KeyBanc Capital Markets

I wanted to ask about the contract segments, if you just comment a little bit more about the underlying trends that you are seeing there. We’ve been hearing that the government spend was a little bit better this quarter and then how the retention of your contract customers has been? And if I could squeeze in housekeeping item as well here, was wondering for the first quarter if could quantify a synergy number for that quarter.

Roland Smith

So from a contract basis as we talked about in our prepared comments, if you eliminate the issues of weather and the calendarization, our sales would have been flat on a pro forma basis this quarter versus previous quarter at 2013. So we are pretty pleased with the progress that we're making in that regard. Also from our prepared comments, you remember that we spoke about the fact that our mix had caused us some margin erosion as it relates to enterprise customers and we are working hard to ensure that as we go forward and we sign new customers that we are using very specific margin expectations before we take on additional business. So we are pleased with the progress we're making in our contract business and expect that we will continue to be able to service our customers as we have in the past and be able to retain the customers that we have and sign new contracts.

Operator

Your next question comes from the line of Mike Baker.

Mike Baker - Deutsche Bank

Hi, guys. I want to ask you about the $75 million of (indiscernible) in store closing, how much of that is coming from sales transfers, what you are assuming for sales transfer, what’s the incremental flow through the bottom line, how much of that $75 million is from just taking the cost out of the close stores? Thanks

Steve Hare

Well, certainly, sales transfer, Mike is a big factor in ultimately how much we will enjoy from the standpoint of synergies as we work towards closing, to be at least 400 stores that we spoke to you about this morning. As we spoke about on our last call, historically, we have enjoyed about a 20% sales transfer. And this has slowed somewhere in the neighborhood of 25% to 30%. And if you do that math that’s what’s driving our expectation of at least $75 million of synergies based on the closing of these 400 stores.

However, we are taking a very disciplined and sequential approach to closing stores. As you know, we expect we will close 150 this year. We will close them as I mentioned later in the year because we want to have them open during the key back-to-school selling timeframe. And so the benefit for 2014 will be minimal, but we are currently in the process of testing ways where we could actually improve our sales transfer rates. We have those tests in market. We are beginning to reap the benefits of those tests. We have some outside consultants that are helping us with that and we believe that based on this and sequentially learning and then applying that to future stores, we will hopefully be able to improve those sales transfer rates and that will allow us to hopefully improve the $75 million to a greater number as we get more information and we improve our execution of closing these stores and maximizing our transfer rates.

Operator

Your next question comes from the line of Matthew Fassler.

Matthew Fassler - Goldman Sachs

Thanks a lot and good morning. I also have a question on store closings and the associated accretion. What proportion of your retail cost base is variable, such that when you close a store, you'll see cost coming out of the business, presumably somewhat of it is somewhat fixed related to distribution, advertising, et cetera?

Steve Hare

Right. This is Steve. What we are looking at and this is where we need to do more work and we will come back to you with a, I think a more detailed quantification of that. But I think as a rule of thumb, you could say that about 25% of our cost would be a variable that could be eliminated as we start to downsize depending on the store, depending on the market and about 75% I think would fit into the category that I think you're referencing, which would be fixed. For example, the marketing spend that we might be doing in a market assuming we would keep that marketing level the same as we reduced a store in a particular market that would have to be absorbed by the remaining store. So, I think at 75-25 rule of thumb, it’s probably a good starting point.

Operator

Your next question comes from the line of Greg Melich.

Greg Melich - ISI Group

Hi. Thanks. I wanted to get a bit into the trends on sales and gross profit dollars. You said the first half of the quarter was harder because of weather but it finished stronger. Was it strong enough to actually be flat by the second half of the quarter, then I had a follow-up on the gross margin dollars, right?

Steve Hare

Well, thanks for your question, Greg. I will reiterate that our sales started off softly because of weather and they did improve. But we did not talk about the specific numbers month-by-month and we don’t plan on doing that. But I’m pleased with the fact that they did improved throughout their quarter. It is only the first quarter, however, and we are still forecasting that sales will continue to decline on the trend that we talked about on our last call. As we look at what happens throughout the second quarter and get a better idea of how much our execution will help us improve sales, we would be able to come back to you and give you a better idea of what we’d expect that to impact as it relates to adjusted operating income.

Operator

Your next question comes from the line of Michael Lasser.

Michael Lasser - UBS

Good morning. Thanks a lot for taking my questions. Two fold, first, looking at your guidance and based on what you did, the core business excluding synergies produced about $58 million in the first quarter, that’s up from $54 million last year. So to get to a $20 million loss for the core business excluding synergies, it’s going to have to lose $78 million after it produced $54 million in the final three quarters of last year on that sort of numbers. Maybe you could help illuminate, what it is that a side -- is it all going to be deleverage associated with fixed cost on a tough sales environment despite trends improving over the course of the quarter? And then my second question is on the 400 store closings. As a group, what was the operating loss or operating profit associated with those stores? Thanks a lot. I know it’s a little hard. I’m sorry.

Steve Hare

Michael, it is Steve. Let me take a crack at those two. As you look at the guidance for the year, the actual adjusted operated income of $72 million versus pro forma last year, you saw an increase of $18 million. Now, again, we had merger synergies that we’ve realized in the quarter of ’14 as part of that and that was a little bit ahead of schedule. But I’d also say, when you look and dig into the quarter, there are some timing aspects of things that hit in the first quarter that I think were favorable that maybe pulled up from the rest of the year.

If I were to characterize that average, I would characterize maybe about half of that could be timing, as you start to think about what that means for the rest of the year. Also to your point around the ability to offset sales deleverage for the rest of the year as Roland said, we continue to think that our sales trends are going to be negative for the year based on historical trends that we’ve seen and the secular declines in some of our key products.

You saw the sales deleverage hit us pretty hard in the first quarter at the gross margin line because we did have a $61 million gross profit decline. So there is significant and not all of that is what I would characterize as sales deleverage, but we had a $130 million lower sales versus pro forma last year with a $61 million reduction of gross margin. And I think that’s why when we look at our floor for the year and going to $160 million, we’ve remain cautious despite the fact that first quarter was favorable because we know, we’re going to see significant sales deleverage for the rest of the year. And that we need to continue to drive our overall cost control to offset that. And that’s really what our underlying assumptions are so we were comfortable going from $140 million to $160 million. And if we get better visibility in the rest of the year, we’ll try to continue to update our view for the year quarter-by-quarter.

As far as the closures, we are not in a position because we really haven’t finalized our analysis yet to stratify and talk about stores that will be closed, that actually are starting with an operating loss. But clearly when we look at the $75 million, it reflects an assumption around elimination of certain amount of stores that are operating at a loss today, plus the improvement that we will get as we transfer sales to existing stores and get the incremental profit on that transfer process.

Roland Smith

Let me just add to that Michael, that as I mentioned in my comments, so we are completing our analysis as it relates to the store closures. We committed on our last call that we would complete that in the second quarter and we still plan to do that. We did want to today give you a preliminary look based on all the work that we’ve done because we are comfortable with the numbers that we talked about today. As we mentioned, at least 400 stores closing by the end of 2016, a 150 of those will be by the end of 2014, and comfortable that we’ll get at least $75 million in synergies.

But to the point about profitability, I would like to remind you that we are looking at six key factors and we’ll continue to look at these six. Certainly, store performance and profitability is one of them, but we’re also looking at sales transfer rates. And as you know, those rates will be defined by specifics, dynamics, and competition in markets. Stranded costs, after the store closes, and that will be defined by lease terms and other factors. Store closing costs expected impact to other channels that we will also look at.

And then clearly our overall go-to-market strategy, which will be informed as we complete our work on our unique selling proposition, which again we talked about coming back to the market and talking about that in more detail at the end of the second quarter. And while I updated you on that today and we feel very good about our progress, we are clearly at the beginning stages of our concept of defining who and then what and then finally how, and that how portion of our USP will be when we actually get into the market and have multiple tests that can validate and help us iterate where our USP will actually go.

Operator

And your final question comes from the line of Dan Binder.

Dan Binder - Jefferies

Hi, it’s Dan Binder. My question was around -- you're buying synergies, just curious you’ve now had several months to talk with vendors. I think you settled on wholesale relationships. Can you just give us an update on where you are on the vendor talks and how much of the synergies that you’ve talked about are already kind of buttoned down at this point?

Roland Smith

Yeah, Dan, great question, I have the update you on that. We have been very pleased with the progress that we have made as we have began to talk to our vendors and talked about purchasing synergies based on the combined companies. I think I mentioned on our last call that we were able in the middle of February to actually hold a large vendor conference here in Boca, where we had representation of over 450 members from our vendor community that came in. We could talk to them a little bit about our 12 priorities and what we’re thinking about doing. And then, we sat down and spoke with them, with our senior team to talk about different areas where we could actually enjoy those synergies.

We updated you today saying that we are on track to achieve the $130 million of synergies that we have spoken about. And quite honestly, we are continuing to be comfortable with that number, even in the light of the fact that we are expecting now to close at least 400 stores. And those 400 stores will obviously have a negative impact on revenue, but that negative impact on revenue is offset by better execution with our vendors to enjoy more synergies and ultimately we had initially contemplated. So we continue to be on track for our synergies, as it relates to cost of goods and we’ll update you on that on a regular basis.

That is the end of our questions. Let me just close by reiterating quickly three points. First, I want to say how pleased we are with our performance in the first quarter. We are improving our execution in all our channels. We’re delivering the integration synergies more quickly than we planned, and we’re managing our SGA very effectively. Second, we remain focused and are making great progress on our 12 critical priorities to include the ones we spoke about today, optimizing our retail portfolio and developing a meaningful USP. And third, we remain confident in our ability to achieve more than $675 million of synergies by the end of 2016 and not less than $160 million of adjusted operating income in 2014. Thanks again for joining us this morning. And we look forward to updating you on our next quarterly call.

Operator

Again, thank you for your participation. This concludes today's call. You may now disconnect.

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Source: Office Depot's (ODP) CEO Roland Smith on Q1 2014 Results - Earnings Call Transcript
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