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Staples, Inc. (NASDAQ:SPLS)

Q1 2014 Results Earnings Conference Call

May 20, 2014 8:00 AM ET

Executives

Chris Powers - Vice President, Investor Relations

Ron Sargent - Chairman and CEO

Christine Komola - Chief Financial Officer

Demos Parneros - President, North American Stores & Online

Shira Goodman - President, North American Commercial

John Wilson - President, Europe

Analysts

Dan Binder - Jefferies

Gary Balter - Credit Suisse

Aram Rubinson - Wolfe Research

Chris Horvers - J.P. Morgan

Michael Lasser - UBS

Kate McShane - Citi Research

Greg Melich - ISI Group

Mike Baker - Deutsche Bank

Brad Thomas - KeyBanc Capital Markets

Matthew Fassler - Goldman Sachs

Greg Hessler - Bank of America

Denise Chai - Bank of America Merrill Lynch

Anthony Chukumba - BB&T Capital Markets

Operator

Good day, ladies and gentlemen. And welcome to the Q1 2014 Staples’ Earnings Conference Call. My name is Allison, and I will be your operator for today. At this time, all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator Instructions)

As a reminder, this call is being recorded for replay purposes. I would now like to turn the call over to Chris Powers, Vice President, Investor Relations. Please proceed, sir.

Chris Powers

Thanks, Allison. Good morning, everyone. And thanks for joining us for our first quarter 2014 earnings announcement. During today's call, we will discuss certain non-GAAP metrics. Please see the Financial Measures and Other Data section of the Investor Information portion of staples.com for reconciliation of these measures.

Certain information discussed on today’s call constitutes forward-looking statements for the purpose 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 factors, including those discussed or referenced in Staples' 10-Q filed this morning.

Here to discuss Staples’ Q1 performance are Ron Sargent, Chairman and Chief Executive Officer; and Christine Komola, Chief Financial Officer. Also joining us are Demos Parneros, President of North American Stores & Online; Shira Goodman, President of North American Commercial; and John Wilson, President of Europe. Ron?

Ron Sargent

Thanks, Chris, and good morning, everybody. Thanks for joining us today. This morning we reported results for Q1 that were in line with our expectations after a slow start to the quarter, trends improved in March and in April.

Our total company sales excluding the negative impact of store closures and changes in foreign exchange rates were down about 2% year-over-year. On a GAAP basis sales declined 3% to $5.7 billion versus the first quarter of last year.

During the first quarter we grew sales in Staples.com, Quill.com and North American Contract and we get back to flat local currency sales in Australia and flat same-store sales in Europe. We also saw sequential improvement in North American retail comps.

Non-GAAP earnings per share for the first quarter were $0.18. During Q1 we had restructuring and other related charges, primarily related to closing 16 stores in the first quarter and about 80 stores during the second quarter of this year.

We also had a tax charge related to the repatriation of foreign earnings, as well as a gain primarily related to the sale of our Smilemakers business. These items had a net negative impact on our Q1 earnings of $0.03 per share.

We are making good progress in re-innovating Staples this, I think, everybody knows on this call, about 80% of our sales are to businesses of all sizes, 60% of our sales are delivered and about half of our total volume is now in categories beyond office supplies.

Our reinvention priorities focused on building momentum in each of these areas, we are driving growth with business customers, we are leveraging our supply chain and omni-channel capabilities, we are building scale and awareness in new categories beyond office supplies and we're taking aggressive action to reduce cost and improve store productivity.

On our fourth quarter call we laid out our plans for 2014 and before we get into the segment results, let me just take a minute to highlight the progress we’ve made during the first quarter and I am going to start with the growth initiatives.

During the first quarter, we invested heavily in the Make More Happen brand campaign to drive awareness with our customers that Staples sells a lot more than just office supplies.

In North American Contract, we saw sales grow 1% year-over-year supported by double-digit growth in facilities and breakroom supplies, as well as accelerating trends in adjacent categories like furniture and promotional products.

We added approximately 300,000 new items on Staples.com in categories like office décor, teaching and education supplies and technology products and we ended the quarter with over 850,000 products now available from Staples online.

We accelerated growth in several industry segments like restaurant and retail stores, by investing in marketing to create awareness and by expanding our assortment of specialty products to serve those industries.

Staples.com grew 6% in local currency driven by increased sales conversion on our desktop and mobile websites, as well as growth from our expanded assortment beyond office supplies. We generated over 400,000 customer orders and grow over 30% growth on our in-store Staples.com kiosk, which is now approaching 5% of our total U.S. retail sales mix.

Copy and print same-store sales in North America grew in the high single digits, driven by strong business customer acquisition. Copy and print sales on Staples.com were up in the double digits supported by improvements we have made to our website.

To build on our momentum in copy and print, we recently announced an agreement to acquire PNI Digital Media, a software company that provides customers with access to personalized print products and services in stores, online and through mobile devices.

We have now re-merchandised over 600 stores in United States with an expanded offering of categories beyond office supplies and remain on track to complete the U.S. chain during Q2.

We improved our mobile offering with the addition of the Apple iPhone about 200 stores in United States and we got back to flat same-store sales in Europe to the first time since 2008.

Turning to our cost reduction and reshaping activities. We secured about $100 million of annualized cost savings so far, with early momentum in areas like marketing, store operations and merchandising. We are also on track to eliminate approximately $500 million of annualized cost over the next two years with about $250 million coming in 2014.

During the first quarter we closed 16 stores and downsized and relocated four stores to the new 12,000 square foot format. We finalized our plan to close approximately 80 stores in North America during the second quarter and we are close to finalizing plan to close approximately 40 additional retail stores during the back half of 2014 and to streamline our supply chain in North America.

While trends in office supplies and technology remained under pressure we made good progress on our key priorities during the first quarter. We still have a lot of work to do this year as we've evolve to meet the changing needs of our customers and reposition Staples as the destination for every products, businesses need to succeed.

Now let’s take a quick look at our Q1 results for each of our three business units, I am going to start with North American Stores & Online. Here sales were down about 2% year-over-year. If you exclude the negative impact of the stronger U.S. dollars and the stores we closed in North America during the 12 months prior to Q1. On a GAAP basis, sales declined 5% to $2.6 billion versus Q1 of last year.

As I mentioned earlier, we drove sequential improvement in same store sales, which were down 4% in North America during the first quarter. Customer traffic was down 4% and average order size was flat year-over-year.

Early in Q1, unfavorable weather had a negative impact on the topline in North American stores with comps down in the high single digits during February. Sales trends improved in March and April and were down in the low single digits. Staples.com sales grew 6% in local currency versus the prior year. This growth was supported by improved conversion on both our desktop and our mobile websites.

Taking a closer look at category trends for North American Stores & Online during Q1, growth in facilities and breakroom supplies and copy and print was more than offset by weakness in business machines and technology accessories, core office supplies, ink and toner and computers.

We are improving the retail experience to better serve our customer. We now have 33 of our new 12,000 square-foot stores and they continue to retain about 95% of our sales. We are on track to downsize and relocated about 25 stores to our 12,000-square foot format during 2014.

We also re-merchandised over 600 stores in United States with an expanded assortment of categories beyond office supplies during the first quarter. Early results are very encouraging and we are driving strong double-digit growth in categories like facilities and breakroom and early education supplies, as well as positive comps and mail and ship supplies and storage and organization. We continue to re-merchandise over 100 stores per week and we're on track to complete the U.S. chain over the next month.

North American Stores & Online operating margin decreased 270 basis points versus last year's first quarter to 3.5%. This was driven by lower product margins, online and in-stores, increased marketing expense to drive awareness of categories beyond office supplies, investments to accelerate growth online, as well as the negative impact of fixed expenses on lower sales. This was partially offset by the progress we’ve made streamlining our store labor model and reducing expenses in our retail stores over the past year.

Turning to North American Commercial, sales increased 1% year-over-year to $2.1 billion. Sales in both Contract and Quill.com grew in the low single digits during the first quarter.

Our team-based selling model continues to gain traction with our enterprise and mid-market customers and we remained focused on accelerating growth in categories beyond office supplies.

Growth remained strong in facilities and breakroom, and we're building momentum in furniture and promotional products. This was partially offset by sales declines in ink and toner, paper and core office supplies.

North American Commercial operating margin for Q1 decreased 74 basis points versus last year to 6.6%. This reflects a decline in product margins, as well as investments in sales force as we continue to add category specialists, strengthen our team-based selling model, partially offset by reduced marketing expense.

In International operations, sales here were down 4% year-over-year to $1 billion versus Q1 of last year. In Europe retail, same-store sales were flat during the first quarter. This was driven by about a 1% decline in traffic and a 2% increase in average order size versus the prior year.

In Europe contract, sales trends continue to stabilize with currency sales down in the low single digits during the first quarter. We are refining our go-to-market strategy to reduce costs, improve customer service and we are seeing improvement in our new customer pipeline across Europe.

In our European Online business, sales were down year-over-year. We continue to take action improve the customer experience and get this business turnaround. After a successful rollout of the Quill platform in Spain, Germany, the Netherlands late last year, we launched the platform in France, Italy and the U.K. during Q1. Online sales are improving in these countries and we are focused on driving customer traffic on our websites improving conversion and increasing average order size.

We’ve made a lot of progress getting our European delivery businesses back on track over the past year. We certainly look forward to building on this momentum in contract and online throughout 2014.

During Q1, International operating margin decreased 152 basis points versus last year to an operating loss of 2.6% of sales. This was driven by the negative impact of fixed costs on lower sales in Europe, lower product margin in Australia and increased marketing as a percent of sales. This was partially offset by higher product margin in Europe due to the progress we have made in creating a pan-European assortment over the last year.

Our teams in European and Australia have made tremendous progress streamlining and transforming our businesses. On our fourth quarter call, we committed to driving profit improvement and further stabilizing topline trends in International during 2014 and we remained on track to accomplish both of these goals for the year.

And with that, I'll turn it over to Christine to review our financials results.

Christine Komola

Thanks, Ron. Good morning, everyone. Total company sales for the first quarter were $5.7 billion. On a non-GAAP basis sales declined 2% year-over-year. This excludes a 1% headwind from changes in foreign currency exchanges rates and stores that closed in North America in the 12 months proceeding Q1 of 2014. On a GAAP basis sales declined about 3% versus Q1 of last year.

During the first quarter, we achieved non-GAAP diluted earnings per share of $0.18 versus $0.26 during the first quarter of 2013. This excludes $46 million of pre-tax restructuring and other related charges primarily associated with the closure of 16 stores during the first quarter and are planned to close about 80 stores in North America in the second quarter of this year.

It also excludes an $11 million tax charge related to the repatriation of foreign earnings and net gain of $22 million, primarily related to the sale of our Smilemakers business during the first quarter.

On GAAP basis earning per share on a fully diluted basis came in at $0.15. Changes in foreign exchanges rate negatively impacted EPS by about a penny during the first quarter.

On a GAAP basis gross profit margin for the first quarter declined 105 basis points to 24.9%, although excluding an $11 million pre-tax charge for inventory write-downs related to supply chain optimizations and store closers, gross profit margin declined 86 basis points to 25.1% of sales on a non-GAAP basis during Q1.

This primarily reflects lower product margins in North American Stores & Online. As Ron mentions, we are making good progress reducing expenses across the business which is helping to fund our growth initiative.

During the first quarter total company SG&A increased less than 1%. Our SG&A rates increased 78 basis points versus last year’s first quarter to 21.6% of sales. This was driven by increase spend in areas like e-commerce and IT, increase marketing to build awareness of our expanded assortment beyond office supplies, as well as investments to drive growth in our key reinvention initiative.

On a GAAP basis total company operating margin decreased 209 basis points during the first quarter to 2.8%. Excluding the restructuring charges and the net gain primarily related to the sale of Smilemakers, non-GAAP total company operating margin decreased 167 basis points to 3.2%.

Effective tax rate for the first quarter was 35.1%, excluding the $11 million tax charge related to the repatriation of foreign earnings, as well as a tax impact of restructuring charges and the net gain primarily related to the sale of Smilemakers during the first quarter, our non-GAAP effective tax rate was 33.5% versus 32.5% last year.

The modest increase in our non-GAAP effective tax rate versus the prior year was driven by changes in the geographic distribution of earning. We are planning for our non-GAAP effective tax rate to be 33.5% for the remainder of 2014.

First quarter capital expenditures came in at $48 million versus $41 million we spent during the same period last year with operating cash flow of about $360 million, we generated free cash flow of $312 million versus $306 million during Q1 of last year.

During the first quarter we repurchased 5.7 million shares for $17 million and currently have $492 million of remaining authorization on our current share repurchase plan. At the end of Q1, Staples had approximately $1.8 billion in liquidity including cash and cash equivalent of about $793 million and available lines of credit of about $985 million.

Now turning to our outlook, during the second quarter of 2014, we expect total company sales to decrease versus Q2 of last year. We expect to continue building momentum in categories beyond office supplies. And we’ll aggressively pursue opportunities to gain share as our industry consolidates. This will be offset by the negative impact of store closures as well as the continued declines in core office supplies, computers and technology accessories.

On the bottom line, we expect second quarter non-GAAP diluted earnings per share in the range of $0.09 to $0.14. Our Q2 guidance does not reflect any potential impact on the earnings per share related to the 2014 global restructuring and other related activities.

The company expects to record a pretax charge in the range of $105 million to $155 million associated with the restructuring and other related activities during the second quarter of 2014. We’ve made good progress in our 2014 restructuring plans.

During the second half of the year, we expect to close approximately 40 retail stores, bringing our total store closure for the full year in North America to approximately 140 stores. We also plan to make progress streamlining our supply chain in North America and will continue to effectively manage expenses in North America and in Europe.

For the first year, we expect pretax global restructuring and other related charges in the range of $240 million to $360 million. For the full year 2014, we remain on track to generate more than $600 million of free cash flow.

Our free cash flow guidance includes an expected use of cash in the range of $60 million to $100 million associated with the 2014 restructuring and other related activities. Our free cash flow guidance also includes the use of cash of between $60 million to $100 million related to 2013 and 2012 restructuring activities.

I'll now turn it back over to Allison for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from Dan Binder from Jefferies. Please proceed.

Ron Sargent

Good morning, Dan. Dan?

Dan Binder - Jefferies

Hello. You there?

Ron Sargent

Yeah. You were gone for a minute there. Could you start beginning?

Dan Binder - Jefferies

Yeah, sure. I was wondering if you give us a little bit of color around the web business with regard to SKUs you’ve added in the last year. How much they are generating and how much of that you’re stocking yourself versus using third-party’s?

Ron Sargent

This business reports to Demos. So I’ll ask Demos to respond.

Demos Parneros

The short answer is on the SKU expansion of all the new categories of vertical. We’re essentially stocking almost nothing at this point and using the third-party’s to deliver that.

Dan Binder - Jefferies

In terms of the volumes that they’re generating?

Demos Parneros

Marketplace sales, I think, they are running around $5 million a week…

Christine Komola

That’s actually (indiscernible). Yeah.

Demos Parneros

And so that’s like the average on obviously picking up steam as we continue to had SKUs, also seeing good momentum on the stores with respect to kiosk sales. So it’s a nice win both for online and for stores. The thing that I’m most encouraged by its customer response has been amazing. They really are having no issue at all and in fact, enjoying the expanded assortment.

Dan Binder - Jefferies

Okay. And my follow-up is on product margins. Ron, you mentioned in a few areas of the business lower product margins. I was hoping maybe you can give us an update on what you’re seeing in the pricing environment, how much do you think you’ve closed the gap in terms of price on core items versus competition? Any color you can around that would be helpful?

Ron Sargent

I’m going to ask Christine to talk margins because really our margin declines are lot more than just pricing. Christine, do you want to start?

Christine Komola

Hi Dan. Yeah, I think if you think about our margins, it’s actually pretty complex. We have couple of things going on in our Neso business. One of them is the 600 reflows that we’ve just done as well as the transition out of holiday during the first quarter. So that that part of the margin as we’ve transitioned out of holiday, take it down, getting rid of that final slug of inventory and transitioning from the old to the new product categories to make sure we were able to do that effectively, in particular, we did have mark downs.

On the web, clearly, you’ve got the pricing, you’ve got dynamic pricing in process on our marketplace SKUs. You’ve got the competitive nature of business mix changing, moving more online technology product. So that was obviously a headwind. And then you do have competition from others online players but you did play a part in the mix.

And then, we’ve also had inflation in our core office supply. So for example, paper, pretty competitive out there and paper cost increases. So trying to pass that on to the customers in the commercial businesses, it does happen but it’s lower than, than we would all like. So that’s a lot of the different competitive environment activity. We do have -- we continue to have a gap with online competitors. And we’re working to close that gap overtime. But it is -- there are as many factors that grow into gross margin.

Ron Sargent

But I think -- to answer your question, I think overtime you have to be competitive on price. And it doesn’t necessarily mean you have to be the same price as others but I think your total offering has got to be competitive. And I think in our case there is a lot more to our value proposition in price whether it’s next day delivery, whether it’s free delivery, whether it’s the rewards program. But all those go into kind of the value equation for customers.

Dan Binder - Jefferies

Great. Thanks.

Ron Sargent

Thanks Dan.

Operator

Next question comes from Gary Balter from Credit Suisse. Please proceed.

Ron Sargent

Hi Gary.

Gary Balter - Credit Suisse

Thank you. Good morning. Just following up a little bit on Dan’s question, just trying to understand, like you mentioned in the comment that you have to be competitive on price. We saw big decline this quarter obviously in the margins in North America stores. Where are you now on price? Like do you feel like you are there or are we going to see continued impact on margins basically through the years because this was the biggest decline you’ve seen in operating margins since Q4 of last year?

Christine Komola

Gary, I think if you think about operating margin there is several factors in that too. On the actual price component of it, I think a lot of that’s going to stem and it’s going to vary by quarter and by what’s going on in the marketplace. So this quarter was as I said, it was partly pure priced. It was partly just overall competition and change of our mix.

There is also petty significant investments that continue to happen in our SG&A which we are partially funding but not completely. And that includes things like the investment in our brand advertising. You don’t see sales come through day one on that but we invested at an all-time high in terms of our brand marketing campaign to drive the assortments. We’ve also invested in our ecommerce business and IT. So that was also part of the…

Gary Balter - Credit Suisse

Does that continue into the next few quarters like we’re going to see that same rate of decline into Q2 and Q3?

Christine Komola

Investments do continue. So it’s partly why you see our guidance going, our EPS down year-over-year. So we are planning to invest in these areas, ecommerce, in terms of our brand marketing. Sales force is a significant investment that takes time to ramp up. We are funding some of it but we do expect to continue some of these our key reinvention.

Gary Balter - Credit Suisse

Since John is in the room, I will ask John the question because international is going to look margin wise a little bit better. And this quarter seem to have deteriorated in -- I don’t know if it’s a one quarter impact because of slower sales quarter although I’m not sure it is. Is there -- could you discuss, what happened internationally?

John Wilson

Sure. Happy to take that one on. I think the biggest disappointment for us on the top line in sales. Our gross margin was up in Europe. Our total operating margin was holding out about 70 basis points in Europe. And basically it was deleveraging on sales some of the fixed cost. The sales surprise, if you want to call that, really related to two or three factors.

One, the transformation, we have number of job actions, number of countries and contract and online, that disrupted our sales. Two, we cut over as Ron mentioned to a new operating model in the system and our online business. And there were some start-up continuing pains there. The good news is we now have 80% of our volume in Europe on the new online platform, Quill. But there were some start-up issues there in the quarter.

And the third factor was we consciously walked away from a number of customers that earned profit on a long-term basis on our online business. And so we looked at our model, we looked at the economics and we cut back at some of our prospecting and some of our targeting of customers who didn’t really have a long-term value for us. That was a constant decision. Those three things led to a mid single negative sales and essentially the variance led to 70 basis points erosion in the margin in fixed costs that we have in the business.

Gary Balter - Credit Suisse

So this, some of this would you say is more one time in nature or am I putting words in your mouth?

John Wilson

A large portion of that was one time in nature.

Gary Balter - Credit Suisse

And then just one follow-up and I’ll get off. Could you talk about like you are preparing to close more stores now. Like you can do 80 next quarter, you did a bunch this quarter. What’s your assumption for the transfer rate of sales to your existing stores?

Demos Parneros

Hi Gary. Sales assumption for transfer to our existing store basis in there 20% to 25% range. We’ve gone back and taken a hard look at prior closing that we’ve done. That seems to be a fairly steady number. And our experience so far in the few closing that we’ve done seems right on track.

Gary Balter - Credit Suisse

Okay. That’s great. Thank you very much.

Ron Sargent

Thanks Gary.

Operator

The next call comes from Aram Rubinson from Wolfe Research. Please proceed.

Ron Sargent

Hi Aram.

Aram Rubinson - Wolfe Research

Hey, good morning guys. Wonder if you can fill us in a little bit on what Wal-Mart’s been doing both with price and assortment and any reason to how they might be setting up for back-to-school if it’s not too early to check?

Ron Sargent

Demos?

Demos Parneros

I think it’s -- hey Aram, how are you?

Aram Rubinson - Wolfe Research

Good.

Demos Parneros

Actually, it’s too early to tell. No one set it yet back-to-school. As you know, we all set up probably in early July and so we don’t have access to their plan. Obviously, we know what they’ve done in the last few years and they do a good job with good assortment, good pricing but I’m really pleased with the preparation of our team.

We’ve taken a hard look at not only last year at what we’ve done, what others have done but taken a look at what we’ve done in the last few years with respect to assortment price, the customer experience in the store, also the online component. We’ve got solid plans, so we are ready to launch in early July but I really can’t say much more about them.

Aram Rubinson - Wolfe Research

Okay. Couple of other things on, first on price, can you -- do you measure the incidents of price matching or request for price matches in your stores and if you do, can you share some statistics with us around that?

Demos Parneros

I can tell you that we do, I don’t have the exact numbers to share with you at the moment. There is going to be a little bit of sort of bigger picture of how we think about that. Back in holiday, we launched our price match guarantee which for stores, I think is really powerful, allow our associates to price match anyone, whether it’s online or stores. It’s actually matching Amazon, Wal-Mart, office supply players. And it’s been well accepted obviously by customers, gives associates a real confidence that we are not going to look at business what kind of our stores. We’ve seen increased activity but at the same times, good sales associate with the price match. And so, I’d say net, it’s a good financial decision for us and a great customer decision for us long-term.

Aram Rubinson - Wolfe Research

Okay. And my last question is for Christine if I could, historically, the first quarter, EBIT has represented about 22% of your full year EBIT. Just wondering if there are things that might be to this year that is just not an appropriate run rate? Thanks.

Christine Komola

Hi. I think if our business changes throughout, I don’t see any major things happening, different kind of year-over-year or this year versus last year in terms of Q1.

Aram Rubinson - Wolfe Research

Okay. Meaning that it shouldn’t be any more pronounced than it has historically, if not, is it -- there were some distorted weather element or just something like that that shouldn’t repeat?

Christine Komola

No. Weather at different times, you never can predict the precise nature of it but we are complex business global thing, so nothing different from what I would predict.

Ron Sargent

So, I think the heavier media spend was maybe made first quarter this year a little different than maybe prior year as well.

Aram Rubinson - Wolfe Research

Terrific. Thank you, guys.

Ron Sargent

Thanks, Gary.

Operator

The next question comes from the line of Chris Horvers from J.P. Morgan. Please proceed.

Ron Sargent

Hi, Chris.

Chris Horvers - J.P. Morgan

Thanks. Good morning. Hi. Can you talk about, as you look at the quarter or so, EPS was $0.18 and you had guided $0.17 to $0.22? So in each of the divisions, can you talk about sort of what were the positive and negative surprises in terms of how the quarter actually played out?

Christine Komola

Sure, Chris. So as you think about each business unit, there is different components that hit them. So, for Neso, weather was tough in the beginning of the year, in the beginning of the month. So we had signed and predict the bounce back on weather stress that happens is difficult. So we had about a 1% impact on that business on sales. They worked hard and the business caught up towards the second and third month of the quarter. I think if you think about the NAC -- our North America Commercial business similar, weather impact was probably about 60 basis points at the beginning of the quarter.

Once again, we saw improvements throughout the quarter from there. Weather was less of an impact in Europe. Europe was probably impacted to John’s earlier conversation on just the start-up and the restructuring activities that are going on in that business. So, I think overall that’s why we give a range of guidance across our business in total to cover for some of these unpredictable things and we feel good that we came in where we were within the range.

Ron Sargent

I guess the only thing I would add is that foreign exchange rates hurt us about a penny during the quarter as well.

Christine Komola

Right.

Chris Horvers - J.P. Morgan

So it sounds like the bounce back in weather came, but maybe that was not as much as maybe you would thought it was and then some of the restructuring in Europe came in and had a bit more of an impact than anyone expected?

Christine Komola

That’s probably a little bit. I mean, that’s why we are within the range. We are comfortable that we were in the range, but yes, I would say that’s fair and why we are little bit towards the lower end.

Ron Sargent

When you look at the first quarter, our comps, I think in the first month, we were about a minus eight, minus nine and in the second two months, they averaged around a minus two and a half, to give you a sense for the bounce back.

Chris Horvers - J.P. Morgan

Okay. And then in terms of -- so the gross -- sounds like the gross margin overall as if, with the exception of some of the disruption was basically where you thought it would play out. Is that fair and we are always trying to figure out how much longer these impacts are and so do you think that in terms of the, how close you are from a competitiveness on price and sort of the integration on adoption of the loyalty card in retail? Are we closer or do you think that this will sort of persist and who knows when it sort of abates?

Christine Komola

I think if you think about the various activities, so we were -- we did predict how we were going to transition in and out of our product lines. They are known as you can never exactly predict customer demand and as new products come out, for example or as technology changes throughout, any of the lifecycle of the technology business. It’s always hard to predict that as well as competition.

Having said that, I think our merchant team is pretty attune to kind of manage it and to get ahead of it and make sure that we manage it, both the inventory that comes in the door, inventory that comes out the door and we try to be as price competitive as possible as well as making sure that we’ve got the right product for the customers.

Chris Horvers - J.P. Morgan

Okay. And then the last one is you’ve been able to extract marketing efficiencies and build North American retail, Neso and then North American contract. Can you talk about what exactly those are? Is that sort of a shift to media? You could see, they are understanding what that is in retail, but unclear what’s changing in the contract side.

Ron Sargent

I’m going to ask Shira to answer this and she is currently heading our marketing for few more days.

Shira Goodman

Good morning, Chris. So the drivers of marketing efficiencies are really three-fold. One would be just, constantly looking for the marketing that is not delivering the returns and eliminating that from the mix. Number two, you are 100% right that it’s in terms of shifting our mix, so much more of our marketing is moving towards digital which does that. High effectiveness for us, both in-store and online. And then the third is obviously the cost of the marketing drive. So we are always looking at how should we purchase it at a lower rate?

Chris Horvers - J.P. Morgan

And then -- and this has been going on for how long? You’ve been marketing it as a source of margin for how long overall?

Shira Goodman

So, I would say that if we look at overall, marketing has been, as a percent of sales flat to declining for a while. I will say in Q1 with the launch of a Make More Happen brand, we really have invested. We took a lot of these savings and we invested it into the brands because we believe the businesses is at a place with what we can actually offer customers, outpace it, how customers perceive us. And we are seeing the brand messaging take root and customer exchanging productions, what Staples stands for.

Chris Horvers - J.P. Morgan

Perfect. Thanks very much.

Ron Sargent

Thanks, Chris.

Operator

The next question comes from the line of Michael Lasser from UBS. Please proceed,

Michael Lasser - UBS

Good morning. It’s from UBS. Ron, you’ve been making a lot of investments on price, people, marketing, what form and when do you expect to see a return on these investments? How as external observers should we expect you to see a return on all these investments that you are making?

Ron Sargent

When you are trying to take a company, the size of Staples, which has had very strong retail legacy and move it into more of an online company. I mean, there is going to be a lot of changes and it’s going to hard to predict exactly when you are going to get back to historical margins. I think there is a lot of indicators that the strategy and the reinvention of the company is working. I mean, we’ve got staples.com sales are growing nicely again after not growing very much.

The assortment expansion seems to be paying dividends. I think we might have mentioned this we will be over a million SKUs by the end of the year. We’ve got some data that says that the brand relaunch of Make More Happen has been well received and is changing perceptions not only of Staples but also Staples versus our competitors. Marketplace, I mean that’s currently running $5 million a week and that’s going to be accelerating I think throughout the year as we continue to add assortment.

Contract is going to have a much stronger year this year than last year. And I think one indicator is that this product is beyond office supplies are now approaching half of our total business, which is part of this reinventing that we are talking about. I think our stores, they are certainly getting more productive with the remodels, with the reflows as well as the closures and the fastest growing part of our company is sales after the kiosk and our stores. And then copy and print, that’s been a really great story and I think that’s going to accelerate with the recent addition of PNI.

So there is a lot of moving parts. It’s hard to say on this date, this operating business will be better than the year before. I think we feel lot more confident about that in international with John’s leadership. And in terms of continued investments, yeah, I think we are going to have make continued investments because it’s very difficult to do the things we are trying to do it and do it on a quarterly basis. So, I wish I could tell you exactly when we will see -- we will be back to historical margins, I can’t. But I can tell you, we are making a lot of progress internally.

Michael Lasser - UBS

Getting back to historic margins, is that the barometer that you are using to measure the success of all these investments in the return profile?

Ron Sargent

I think you will always kind of say where was the high point? I think the business has changed a lot. I mean, we are going to selling a lot less paper-based office supplies in the future than we’ve sold in the past. So you’ve got product shift moving from real asset to digital assets, from paper based to technology based which has a lower margin.

You’ve got channel shift from retail to online and then you’ve got competitive shift where I think many of our competitors are going to be even tougher priced than maybe in the past. I think to me the key is not necessarily gross margin rate or operating margin rate, is do I expect to pass margin dollars from a historical basis like, I certainly do.

Michael Lasser - UBS

Okay. And I imagine as part of that the [QB] (ph), the new profile, the smaller stores, you’ve got 33 of the 12,000 square foot locations. Demos, maybe you could give us a little bit of insight into profitability and the margin profile of those locations? Thank you very much.

Demos Parneros

Yes, sure, Mike. So a couple of quick highlights on the smaller store format, we’re thrilled with it. First of all, it’s progressing very, very nicely. We mentioned 33, we’ve got 25 in Q, and we are negotiating lease renewals to the smaller. It’s tough to do downsizing honestly. Landlords are -- it’s not their favorite thing to do, because it’s costly. So it’s got to be a win for both of us and where those opportunities exist, we are taking advantage of them.

In terms of the actual box itself, we continue to refine it. So we’ve been working hard on a few fronts. One, what’s inside the box, the product mix. So we’ve been continuing to tweak the assortment and we feel like it’s in a good place. We’re retaining roughly 96% of sales, almost that same number for margin, so the product mix is on our radar, but we are satisfied with it.

Probably the most exciting thing that we have done is taken some cost of the actual remodel itself, the actual downsizing work. And so the payback period has been shorten, that will enable us to go much faster in the future. So it’s a viable growth tool for us sitting there. And as we evaluate leases at the end of each -- along each year, we will be able to really push these and do many more of these. So it makes the productivity of the store much, much better obviously to have almost the same sales with just about half the sales. And think about Ron’s comment, margin dollars actually from a per foot basis are much better. Overall profitability gets better after we pay back for the construction. So, very encouraging on all fronts.

Michael Lasser - UBS

Okay. Thank you very much.

Operator

The next question comes from Kate McShane from Citi Research. Please proceed.

Ron Sargent

Hi, Kate.

Kate McShane - Citi Research

Hi, thanks. Good morning. I was wondering if we could hear a little bit more about the profile of stores that you have closed and are closing this year, where are they located and if they were unprofitable? And generally, what is the criteria you think to close stores?

Ron Sargent

Demos?

Demos Parneros

Sure. So the pretty straightforward approach. When we announced our store closing program, we went really after the unprofitable stores as well as the few stores that were overlap stores where we felt we can close stores and still retain a huge portion of the sales. So to zero it on this quarter, I would say that the privatization for our team has been stores with high transfer rate, so we are experiencing good transfer rates on the ones that we’ve closed. Stores that we felt were structurally broken that were not worth the fight to try to fix. We are going to basically cut the cord with those.

In terms of the characteristics and geographies, there is spread honestly throughout. They are not only in area. We’ve closed everywhere from Florida to New York to the Midwest, I mean they are pretty much scattered throughout the country. They are generally lower volume stores, lower margin stores to put a little bit of a picture on them. They are larger stores. They average about 19,000 to 20,000 square feet. So that’s very quick kind of headlines on what we’ve been focused on at the moment.

Kate McShane - Citi Research

Okay, great. And then just to back to the pricing conversation not to be the dead horse, you had mentioned that there is still this gap between yourself and some of the online retailers. What about between you and the other brick and mortar retailers from a price gap perspective?

Ron Sargent

Yes. I would think we did the survey and we do the survey with online as well as bricks and mortar. I think it depends on whether it’s a promotional time of the year or not. So for example back to school, I mean, any competitor could have a better price than Staples in one week and Staples could have a better price than any competitor another week. But in terms of like kind of the everyday pricing, I would say that we are certainly very, very competitive in the office superstore industry. We are heading this in terms of the mass merchants. And I think in terms of our biggest online competitors, I think we are probably still little high in terms of exact price, but we are doing a lot more price matching at retail. We are doing a lot more dynamic pricing where we are changing prices several times a day in our online business. And I think we are probably closer than we have ever been.

Kate McShane - Citi Research

Okay, great. Thank you.

Ron Sargent

Thanks, Kate.

Operator

The next question comes from the line of Greg Melich from ISI Group. Please proceed.

Ron Sargent

Hi, Greg. Good morning.

Greg Melich - ISI Group

Hi. Two questions. First was on the remerchandising efforts, I think Ron you mentioned double digit in the categories that changed. Demos, could you give us any idea as to how the whole store is doing, the ones that have been remerchandised and how it takes to build?

Demos Parneros

Hi, Greg. We are seeing good growth in some of the new categories. The headline stars on cleaning and breakroom and it’s going to success for all channels at Staples. We are excited to have it, expand in stores as well. In the first round, I mean, just keep in mind, we started this just a couple of months ago. Based on average frequency of trip most customers haven’t seen these and appreciated these reflows yet. So we are still waiting for customers to make repeat trips into the store, but I would say instantly good response on cleaning and breakroom as well as some of the other categories that we’ve grown.

In terms of overall lift to the store, I would say probably a little bit too soon to tell honestly. We need to see a couple of months’ worth of sales to determine that. But as we see each wave of -- we do about a 100 per week at this point. It takes about a week or so for the dust to settle and for customers to even realize what’s going on, frankly.

So I would say that the feedback from customers, stuffs that we have done in stores, just the sales data that we’re evaluating everyday and then just anecdotal feedback from our associates all thumbs up. Obviously if something doesn’t work, we will change it quickly and move. But I would say so far so good and we will be able to be a lot more specific about the future. We will be having this entire initiative wrapped up probably in the next five weeks, well, since we have done.

Greg Melich - ISI Group

So hopefully by the end of the next quarter we can get a little more insight on that?

Demos Parneros

No question, absolutely.

Greg Melich - ISI Group

Okay. And then the second question was on the cash flow side, I’ve seen the $600 million that you have, just want to see does that include any working capital benefit or expense this year?

Christine Komola

There is a little bit of working capital benefit, but not, we are not assuming a significant change in that, but there is some.

Greg Melich - ISI Group

Okay. And then on the restructuring part of that, thanks for that table, that’s super helpful. If I get my math right, if it’s $60 million to $100 million of expense in cash this year that leaves about 120 t0 170 that would flow in future years of restructuring cash?

Christine Komola

That’s right.

Greg Melich - ISI Group

Okay, that’s great. Thanks a lot. Good luck.

Ron Sargent

Thanks, Greg.

Operator

The next question comes from Mike Baker from Deutsche Bank. Please proceed.

Mike Baker - Deutsche Bank

Hi, thanks. Two questions. One, you talked about the transfer rate in the store that you closed. What have you seen from transfer rates or share pickup from stores that your competitor may have closed? And then the second question sort of others have asked questions similar to this, but you have $500 million in SG&A savings over three years and you said you have about $100 million that you have done already. Clearly it’s offset by investments or just loss of sales because your SG&A was up slightly. So can you help us sort of figure out how much of that $500 million eventually flows through to the bottom line? Thanks.

Ron Sargent

Demos?

Demos Parneros

So let’s start with your store question. So as we discussed before the transfer rate on closures with our own stores obviously we know exactly what the situation is without stores. We’re in that 20% to 25% rates depending upon the distances between the stores and the overlap there.

With respect to competitor stores closing, honestly we haven’t seen the bulk of the consolidation closings yet. We have seen some closings. I would say that the transfer rate for those is lower where they -- I mean our expectation is that if they close stores that are overlapping to themselves that they will basically get more benefit than we would. So we expect the more modest transfer from that. But given the vast number of store closings, we are probably looking for maybe half that, maybe like 10% to 12% transfer. We would be happy to get that. In the meantime, we will prepared and ready to go after customers in either scenario to make sure that we re-point them towards Staples stores and staples.com.

Christine Komola

And Mike on your question about the SG&A flow-through of the $500 million, so we are continued to be very excited about the progress that we’ve made. We’ve got identified about $100 million related to this year. Our goal this year is about 250 and it is a ramp of the savings. So we’ve identified things and have things in process related to store labor models, related to procurements, IT contracts, marketing which we’ve talked on. And I think that as you think about the investments that we’ve continued to make that also ramps up over time. So, sales force takes time to pay off as we talked about between 12 and 18 months. So feel good about the progress and we are definitely at the early stages.

Mike Baker - Deutsche Bank

Okay. If I could ask one follow-up. I am just curious, I mean, the other guys talk about transfer rates in the 25% to 30% range, if you pick up 10% to 12% as well. Just curious what’s your view on, what is the other 50%, 60% kind of whatever it is, where does that go? If they are closing stores and it doesn’t to go them and it doesn’t go to you who gets it? Thanks.

Ron Sargent

I guess it goes everywhere. I mean when you think about the market share of Staples or even Staples plus Office Depot, it’s a pretty small share of a pretty big market. So it could go to contract, it could go online somewhere, it could go to mass merchants, Walmart, Target, Kmart there, but it’s just hard to exactly calculate. We obviously keep a lot more of our own stores and we close store nearby, but you just do transfer less when a competitor closes a store near you.

Mike Baker - Deutsche Bank

Okay, thanks.

Ron Sargent

Thanks, Mike.

Operator

It’s from Brad Thomas, KeyBanc Capital Markets.

Ron Sargent

Hi, Brad.

Brad Thomas - KeyBanc Capital Markets

Hey, good morning. I want to ask a follow-up on retail as well and I apologize it will echo your own. I want to ask a follow-up on retail as well. When on last call you announced plans to potentially close as many as 225 towards over the course of 2 years, obviously provided more detail on the number of closures for this year today. But just in light of the detail that Office Depot has provided about closing at least 400 stores over the next three years. I was hoping Ron, Demos, maybe you could give us any updated thoughts on store closures over the next couple of years?

Ron Sargent

Yeah. I think, we said last quarter is that we’ve got 225 stores that we feel like we need to close and that’s our plan. I’m sure there is going to be some stores that will kind of fall into that and there will be some stores that will come out of that based on what we see with Office Depot closures. But we think 225 is the right number and a good number and I think that will kind of position us well for our retail footprint going forward.

You look at our average sales per store, I think it’s about $4.8 million per store and you compare that to 2013 Office Depot sales per store around $3.6 million per store. So I gave you my kind of thoughts on how many stores we felt like could operate in the U.S. in the long term and I still don’t think we are -- if you add the two together, you still don’t quite get to my number.

Brad Thomas - KeyBanc Capital Markets

Great. I mean, if I could just follow up on the expense questions a little bit of a different way. This quarter was the first in a couple of years that we saw the expense dollars up, obviously you listed a number of various you made investments. As we look ahead to the second quarter, do you think that’s another quarter that we would see the expense dollars up again?

Christine Komola

Well, we don’t give one item details. I think you can see that the bottom-line we are continuing to make investments given the fact that we’re -- our range is between $0.09 and $0.14 and sales are coming down year-over-year.

Brad Thomas - KeyBanc Capital Markets

Okay, great. Thanks so much.

Ron Sargent

Great. Thank you, Brad.

Operator

The next question comes from the line of Matthew Fassler from Goldman Sachs. Please proceed.

Matthew Fassler - Goldman Sachs

Thanks a lot. Good morning. I have two questions. Another follow-up on the store closing thought process. If we think about that sales transfer rate for revenues coming either from your own stores or from Office Depot closings, how should we think about the incremental margin that you generate on those revenues relative to the base operating margin of the North American stores and the online business? Are you thinking about something in the 20% range or higher than that, given that there should be relatively little incremental expense coming in for those revenues?

Ron Sargent

I think you’re right on target, Matt. It’s about the right number 20 to 25. I would say it’s petty good clean flow-through as we move sales to neighboring store, so that seems to be with our line of thinking.

Matthew Fassler - Goldman Sachs

And then my second question is, if you could just lend us a little bit of color on supply chain rationalization, what kind of changes to the infrastructure you would anticipate particularly as you downsize the retail network?

Ron Sargent

Sure.

Christine Komola

Good morning, Matt. So actually a lot of our supply chain focus is on the delivery side of the business. And as the business changes and we expand into new categories where we look at our supply chain in several ways. First of all, are we stock into right SKUs in our supply chain to optimize both return and cost of goods and so. And we’re obviously looking at the labor structure and the actual network. Obviously, next day delivery is the key differentiator and one that our customers really value, but we’re always looking for ways that we can deliver that more cost effectively without disrupting the business.

Regarding the closure of the retail stores, we’ve actually done a very nice job over the last couple years managing our retail distribution cost. And we would envision that we only have four distribution centers that are geographically located to supply our retail store, so we don’t see a major change there, but it would continue to (indiscernible).

Matthew Fassler - Goldman Sachs

One quick follow-up if I can. So it became clear I think as 2013 ended and we heard from Office Depot and from you through the period that late last year prior to the merger OfficeMax had pushed pretty hard on some contracts and probably impacted pricing for new deals in the delivery arena. Can you talk about the competitive environment for new business and business retention in commercial and delivery over the past 3 to 6 months as that deal has stabilized?

Christine Komola

Sure Matt. So I would say that pricing is relatively stable these days. And in terms of the competitive environment, we are seeing that our customers are less likely to go out to bid so our retention rates have been strong. They don’t feel like it’s a good time to really test the water given the uncertainty of the competitive set, so that has worked well for us. Overall, the contract business, really the big story is to grow in beyond office supply. And that’s the place where we believe we’re finally ahead of the competition in terms of the assortment and our ability to really deliver a solution to our customers.

Matthew Fassler - Goldman Sachs

Great. Thank you.

Ron Sargent

Thanks Matt.

Operator

The next question comes from Greg Hessler from Bank of America. Please proceed.

Ron Sargent

Hi, Greg.

Greg Hessler - Bank of America

Hi. Good morning. I know that you guys borrowed a little bit on commercial paper during the quarter. Just want some of your various initiatives. And I think free cash flows, typically a little bit of the drain in the second quarter as you sort of build inventory ahead of back-to-school. So my question was, how do you feel from a cash standpoint? And do you think you might borrow in the second quarter to help fund some of these things?

Christine Komola

Hi Greg. Yes, you’re right. We did borrow on CP program and you’re also right that we do in Q2, have more of a build into the cash. So, I think we had kind of ordinary course of business. We monitor cash flow and feel comfortable with aspect to commercial paper as necessary. We’ll use that as well as cash that we did bring home into the U.S. to cover our cash flow needs.

Greg Hessler - Bank of America

Okay. And then just want to follow-up for modeling purposes. Is there any guidance you can give us on where we should expect full year rent expense to shake out?

Christine Komola

Yeah. We don’t see anything unusual and we don’t give specific one item guidance on that.

Greg Hessler - Bank of America

Okay. Thank you.

Operator

The next question comes from Denise Chai. Please proceed.

Denise Chai - Bank of America Merrill Lynch

Okay. Thanks for taking my question. So following up on Greg question about cash being repatriated, can you tell us how much you did repatriate and what the mix is currently in terms of U.S. and overseas and if there is any particular reason for the repatriation?

Christine Komola

Sure. So we did bring home cash this quarter and primarily, we’re always discussing the needs around the world, around kind of what our cash flows look like. So we saw an opportunity to bring some of the cash home and therefore, took advantage of that opportunity. We -- on a, kind of a -- where our cash is located, we’ve got the cash in half of it in the U.S. and the rest is kind of distributed throughout the world.

Denise Chai - Bank of America Merrill Lynch

Okay. All right. Thanks. And in terms of your $600 million of free cash flow guidance, this does now include proceeds from sale of Smilemakers?

Christine Komola

Yes. It does, Denise.

Denise Chai - Bank of America Merrill Lynch

Okay. Great. Thank you very much.

Operator

The next question comes from the line of Anthony Chukumba from BB&T Capital Markets. Please proceed.

Ron Sargent

Hi, Anthony.

Anthony Chukumba - BB&T Capital Markets

Good morning. Just had a quick question, there have been some questions about Office Depot and store closings and transfer rate. I guess I was just wondering what you’re seeing in the commercial business. Have you -- all your sales were up a little bit but do you see any benefit from customers nervous about the integration? I know you mentioned it helps your contract retention rates. But I was just wondering if you’re seeing, having any wins on that side of business aside from Guy Brown which you talked about earlier?

Christine Komola

Right. So, Anthony, as you know, obviously, you have to really do the heavy lifting of integration in terms of product assortments, system integration, EPSi integration. So as a result, I think customers are not quite feeling and we’re not seeing the large flow through on acquisition. Having said that, we are out there on the market, we are talking to customers a lot to help them understand what is coming down the road. And with our own customers, as I said, it’s definitely on a positive, that kind of less reason to embark and try a new supplier.

Anthony Chukumba - BB&T Capital Markets

Got it. And then just one follow-up question. You mentioned 20% to 25% incremental margin on sales from close stores. I mean, do you have any sense for what the incremental margin would be -- let’s say, if you picked up a sizable Office Depot, OfficeMax contracts?

Ron Sargent

The size.

Christine Komola

Yeah. It depends on the size and the products that they actually acquired, that’s a pretty dynamic question.

Anthony Chukumba - BB&T Capital Markets

Got it. Okay. That’s helpful. Thank you.

Ron Sargent

Thanks Anthony.

Operator

I would now like to turn the call over to Chris Powers for closing remarks.

Chris Powers

Well, thanks. Thanks everybody. Thanks for joining us on the call this morning. We look forward to speaking with all of you again very soon.

Operator

Thank you for joining today's conference. This concludes the presentation. You may now disconnect. Good day.

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