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Office Depot (NYSE:ODP)

Q2 2011 Earnings Call

July 26, 2011 9:00 am ET

Executives

Brian Turcotte - Vice President, Investor Relations

Charles Brown - President of International

Steven Schmidt - Executive Vice President of Corporate Strategy and New Business Development

Kevin Peters - President of North America

Neil Austrian - Chairman, Chief Executive Officer, Member of Corporate Governance & Nominating Committee, Member of Corporate Governance & Nominating Committee and Member of Finance Committee

Michael Newman - Chief Financial Officer and Executive Vice President

Analysts

Joseph Feldman - Telsey Advisory Group

Daniel Binder - Jefferies & Company, Inc.

Kate McShane - Citigroup Inc

Jason Campbell - Macquarie

Ryan Brinkman - JPMorgan

Christopher Horvers - JP Morgan Chase & Co

Colin McGranahan - Sanford C. Bernstein & Co., Inc.

Brian Nagel - Oppenheimer & Co. Inc.

Michael Baker - Deutsche Bank AG

Operator

Good morning, and welcome to the Second Quarter 2011 Earnings Conference Call. [Operator Instructions] At the request of Office Depot, today's conference is being recorded. I would now like to introduce Mr. Brian Turcotte, Vice President of Investor Relations, who will make a few opening comments. Mr. Turcotte, you may now begin.

Brian Turcotte

Thank you and good morning. With me today are Neil Austrian, Chairman and Chief Executive Officer; Mike Newman, Chief Financial Officer; Kevin Peters, President, North America; Charlie Brown , President, International; and Steve Schmidt, Executive Vice President, Corporate Strategy and New Business Development.

Before we begin, I would like to remind you that our discussion this morning includes 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 are contained in the company's filings with the SEC.

In addition, during the conference call, we refer to certain non-GAAP or adjusted financial measures. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP financial measures, as well as our press release and accompanying webcast slides for today's call, are available on our website at www.officedepot.com. Click on Investor Relations under Company Information.

Neil Austrian will now make a few opening comments and then summarize Office Depot's second quarter 2011 earnings. Neil?

Neil Austrian

Thanks, Brian, and good morning. Before I review our second quarter 2011 results, I would like to comment on the Board's decision to name me Chairman and CEO of Office Depot on May 23, and I'll also comment on our recent organizational announcement.

In regard to the CEO search, the search committee met with many qualified candidates who were excited about the opportunity. But near the end of the process, the Board recognized that I have made measurable progress during my 7 months as Interim CEO and began to rethink their decision to introduce a new leader at this time.

As a result, the Board decided that I was the best person to lead Office Depot to return to profitable growth and to attract talent and build bench [ph] strength for the feature. I'm both flattered and humbled by the strong confidence expressed in me by the Board, and I've committed to all of our 40,000 associates that we'll work together to return this company to the performance levels previously achieved.

Concerning the announcement made on July 13. We made organizational changes to drive profitable sales in all of our channels to better leverage our infrastructure and assets and build our brand. These changes included the appointment of Kevin Peters as President, North America, a new position combining the company's previous North American Retail at North American Business Solutions division. In his new role, Kevin will be responsible for all customer-facing sales channels including Retail, Contract, Direct and E-commerce and the PEL -- P&L in North America.

For the first time, we are consolidating all of our North American operations under one leader, allowing us to break down silos, increase our productivity and improve the execution of our key initiatives. We're confident that this approach will help us to better serve our business customers and consumers.

In addition, we announced several other changes including Steve Schmidt being named Executive Vice President, Corporate Strategy and New Business Development; Bob Moore was named Executive Vice President and Chief Marketing Officer; Farla Efros named Interim Head of Merchandising; and Michael Allison promoted to Executive Vice President, Human Resources.

I believe we now have the right priorities, the right people and the right structure in place to successfully execute our plans, accelerate our growth and make Office Depot a stronger competitor in the marketplace.

We thank Daisy Vanderlinde, our previous Head of Human Resources, and Monica Luechtefeld, our previous Head of E-commerce and Direct Marketing, for their many contributions to Office Depot and wish them well as they retire from the company after many years of valuable service.

We'd also like to thank Dave Fuente, who resigned as a member of the Board last week to pursue other professional interest. Dave has been a valuable member of our Board since 1987, and we wish him well.

Turning to Office Depot's second quarter 2011 results. Sales totaled $2.7 billion, essentially flat compared to our second quarter results in 2010. On a constant currency basis and excluding sales related to asset dispositions and deconsolidation in the fourth quarter of 2010 and an acquisition in the first quarter of 2011, total company sales in the second quarter of 2011 decreased about 2% versus prior year. The company reported a net loss, after preferred stock dividends, of $29 million or $0.11 a share in the second quarter of 2011 versus a net loss of $25 million or $0.09 a share in the same period a year ago.

Second quarter 2011 results included charges primarily related to restructuring activities and actions to improve future operating performance. Excluding these charges, which totaled $20 million before tax, the net loss after preferred dividends was $17 million or $0.06 a share.

Total company gross profit margin increased about 90 basis points in the second quarter of 2011 compared to the prior year. This was driven primarily by gross margin improvements in North America Retail and BSD. Second quarter gross margin was relatively flat versus the prior year in the International division.

Total company operating expenses adjusted for charges were down $4 million compared to the second quarter of 2010. EBIT adjusted for charges was $11 million in the second quarter of 2011 compared to an EBIT loss of $23 million in the prior period. The significant year-over-year improvement was primarily due to better results in North American Retail and a strong quarter from the Business Solutions division. Mike will further review the second quarter financial details later in the call.

I'll now ask Kevin to review North American Retail's second quarter 2011 performance.

Kevin Peters

Thanks, Neil, and good morning. In the North America Retail division, second quarter 2011 sales were $1.1 billion, down 2% versus one year ago, and same-store sales were down 1%.

You may recall that we previously reported that April same-store sales were positive and anticipated that the second quarter would be slightly positive as well. However, May same-store sales were down 2%. In June, the highest sales volume month of the quarter, was down 3%. The reversal in same-store sales trends during the period were mainly driven by an unexpected significant decline in computer sales in the back half of the second quarter. Excluding sales of computers and related items, same-store sales in June would've been relatively flat. It's interesting to note that, although our overall notebook computer sales volumes declined year-over-year in the second quarter, the NPD Group Retail Tracking Service indicates that we gained dollar share in notebook computers within the office superstore channel. If we look at average order value and customer transaction counts, AOV rose 1% during the second quarter versus the prior year while customer transaction counts declined about 2%.

Turning to our product categories, furniture comp sales were positive again in the second quarter as seating remained strong. Other key product groups showing year-over-year improvement in the second quarter included storage items, printers, writing instruments and cleaning and breakroom supplies.

Total peripheral sales comped negatively again in the second quarter, which drove the overall division sales comp decline. The good news is that the peripheral sales decline improved sequentially, and we continue to take actions to drive sales within that product group going forward.

Growing sales of our high-margin service offerings continued to be a great opportunity for our Retail business. In the second quarter, Tech Depot Services again reported double-digit sales gains versus the prior year and Copy & Print Depot comped positively for the sixth consecutive quarter.

We are encouraged that these value-added services are gaining awareness with our customers, and we will continue to allocate resources to drive their growth. Our goal to increase direct import of products continues to go well. Penetration in North America Retail was at a increased 300 basis points versus the same period last year.

If we look at our second quarter same-store sales on a regional basis, 4 regions showed flat to improving trends versus the prior year. Unfortunately, California reversed the positive trend from earlier in the year and declined for the quarter. We believe this decline was due to state budget cuts and a relatively high unemployment rate resulting in continued low consumer and small business confidence.

Our North American store count at the end of the second quarter was 1,131 stores. During the quarter, we opened 4 new stores and closed 14 stores. We closed our remaining 10 stores in Canada in the second quarter of 2011, but we'll continue to serve our Canadian customers through our BSD division. We remodeled 5 stores and relocated 4 during the second quarter, successfully reducing the square footage in those 9 locations by about 30% on average.

North American Retail reported operating profit, excluding the $12 million in charges for the Canadian store closures, of $15 million in the second quarter of 2011 compared to $9 million in the same period of 2010. The charge is primarily related to accrued lease costs as well as severance and other closures. The increase in operating profit reflect 80 basis points of gross margin improvement, including lower property costs. Additionally, reduced advertising expenses and the division's portion of benefits that should not recur, including removing recourse provisions from Office Depot's private label credit card program, were some of the improvement in operating profit. These benefits were partially offset by the negative flow-through effect of lower sales in investments in our key growth initiatives.

Earlier this year, I outlined 4 initiatives for North American Retail to drive sales and reduce costs. I'll now update you on the progress of those key initiatives.

First, we've moved into the second phase of our plan to improve the customer in-store shopping experience, which involved expanding the pilot to 28 stores in 2 districts in June using 2 different transformation models. Once we determine which model provides the optimal solution to deliver results, we will begin rolling out the model to approximately 300 stores in the fourth quarter of 2011. The key here is to increase the customer conversion rate in our stores and turn dissatisfied shoppers into very loyal customers.

Second, we're investing in our Copy & Print Depot and Tech Depot Services. These 2 solution-based businesses continue their strong year-over-year gains in revenue in the second quarter and provide Office Depot the opportunity to differentiate in the markets. In Copy & Print, we've added incremental in-store and outside sales expertise as well as increased our marketing spend to drive awareness. To drive Technology Services, we're piloting a redesigned technology area with an optimized assortment and dedicated selling resources in 2 markets. We are encouraged with the results to date, and our plan is to launch this model across a significant number of stores in 2012.

Third, we are focused on improving the sales productivity of our stores. This includes remodeling about 50 traditional stores into our M2 format in 2011 and reducing the average store size wherever possible. We've been making progress as evidenced by the fact that we've reduced the average store size of our remodels and relocations by 20% to 30% over the past 3 quarters. In addition, we continue to test our new smaller concept store, and although we continue to tweak the model, the results to date indicate that services can successfully drive profitable sales in the small store format.

And then lastly, we continue to pursue opportunities to improve margins, including increasing direct import penetration, pursuing the harmonization and rationalization of SKUs and taking a much more disciplined approach to pricing promotions and measuring their effectiveness.

We are extremely excited about these initiatives and believe that improving the in-store experience, reducing occupancy costs and promotional discipline could benefit North American Retail operating income in the range of $75 million to $100 million annually by 2013. We'll have more to say about these initiatives and the projected benefits in the next few quarters.

Third quarter is Back-to-School season, and we plan on offering our customers the best value possible with new lower prices on over 75 top Back-to-School supplies. We will bring the savings message to life in the store, online and in media, highlighting new and exciting fashion products and popular national brands. And because business is built on relationships, we're committed to giving our Worklife Rewards members and our Star Teachers special treatment throughout the year. And for Back-to-School, they'll receive VIP offers during private events we are holding just for them.

In addition, we're excited about offering 8 tablets in time for Back-to-School this year. Our tablet offerings currently include the HP TouchPad , the ASUS Transformer, the BlackBerry Playbook, the Toshiba Thrive, the Acer Iconia, the Lenovo IdeaPad, the ViewSonic G-Tablet and the Velocity Micro Cruz. We are offering all of the accessories our customers need for these great new tablets, as well.

Looking at the third quarter of 2011, we expect our year-over-year same-store sales trend to be consistent with the second quarter, which will be down versus the prior year. However, despite softer sales, we expect our operating profit to be up slightly as we continue to improve product margins and reduce occupancy cost while continuing to invest in our key initiatives.

Although Steve Schmidt is already transitioning into his new duties as Executive Vice President, Corporate Strategy and New Business Development, he will do double duty today and report on the second quarter results for the North American Business Solutions division. Steve?

Steven Schmidt

Thanks, Kevin, and good morning. I'm very excited about my new role, which will include the tactical development and implementation of our strategic plans, integrating our own brands across the globe while optimizing our direct import and global sourcing strategies and new business development. I look forward to working with the executive team on driving change and profitable growth in this capacity.

Turning to the North American Business Solutions division, second quarter 2011 sales were $803 million, down 2% versus the same period last year. The rate of sales decline was slightly better than the first quarter rate, and the entire sales decline is equivalent to the sales not retained during the transition to our new public sector purchasing consortiums. Our sales results were lower than original expectations due to softness in the public sector overall and lower growth unexpected with small- to medium-sized business customers.

Looking at our second quarter sales by product category, we did see positive year-over-year sales growth again this quarter in seating and cleaning and breakroom supplies. We continue to gain traction in breakroom supplies with the sales rate improving at a double-digit rate again in the second quarter. The paper group sales declined at a rate consistent with the division average, while ink and toner sales were lower. I should note that cut-sized paper price increases were announced by the North American paper producers for June 2011, and we believe that the impact on profitability will be neutral to slightly negative in the third quarter as we attempt to pass through the cost increases to our customers.

Geographically, the second quarter sales rate in Texas and Florida, versus the prior year, were better than the overall BSD rate, while California was slightly worse due to the continued macroeconomic weakness in the state, as Kevin did mention earlier.

BSD's second quarter average order value was down to last year, and customer transaction counts were lower as well. While discretionary spend appears to have stabilized, we still have not seen a significant change in discretionary purchases by our customers at this point in the economic recovery.

If we look at the Direct channel, sales in the second quarter were down 1% versus one year ago due to increased competitiveness and paid Internet search and the concerted effort to reduce promotional support to better manage our bottom line.

Turning to the Contract channel, sales declined about 2% versus last year, which was equivalent to the sales not retained during the January 2011 transition to our new public sector purchasing consortiums. In addition, I'm pleased to report that we retained this business at an 86% rate in the second quarter, and we're beginning to see some customers previously lost to other providers returning to Office Depot because of our superior service model.

If we look at the other parts of our Contract business, we achieved positive sales growth sales with our large national account customers again this quarter. In addition, sales to small- to medium-sized business customers or SMB in the second quarter grew slightly versus the prior year. This is the first quarter-over-quarter, year-over-year growth in SMB since 2008 and shows that we are beginning to get traction in this key customer group. However, we continue to see weaknesses in the state government area and some volatility within the federal government business as these customers experience budgetary pressures.

Second quarter 2011 operating profit for BSD was $45 million, up significantly from the $14 million reported in the same period one year ago. The $31 million year-over-year increase in operating profit was driven by 150 basis point gross margin increase, operational improvements and some discrete items that will not recur in the future quarters.

On the operational side, we were successful in reducing distribution, advertising and payroll expenses as part of the initiative to improve the division's overall cost structure. These reductions were rooted on a greater level of fiscal discipline and involved a strategic implementation of low-return or no-return expenses. The discrete items that should not reoccur totaled approximately $10 million in the quarter and included benefits from removing resource provisions from the Office Depot private label credit card program and adjustments related to customer incentive programs.

In North American BSD, we continue to focus on 3 key initiatives to drive sales and improve margins in an environment that remains challenging. I'll now update our progress with these initiatives for you.

First, we are determined to increase our customer mix of SMB customers. This initiative continues to be a priority, and we feel that we are gaining traction and as evidenced by our positive sales growth in the second quarter.

Second, we are continuing to grow our Copy & Print business with a year-over-year improvement in the second quarter. Copy & Print sales recorded in the Retail channel continued to show strong growth as we have successfully expanded this service to our Contract customers in most markets using capabilities in both our retail stores and the 9 regional print facilities in the U.S.

And third, we continue to look at every area to offset margin pressures and improve the bottom line. This would include reducing overhead and supply chain expenses and taking a more disciplined approach to promotions and measuring their effectiveness.

In summary, we continue to win new business and retain existing business in the Contract channel, and our Direct channel continues to perform well and maintain its competitive position in this market. We also feel that some of the actions taken around fiscal discipline and our cost structure in 2010 are taking hold and then driving improved operational performance.

In regard to the third quarter 2011 outlook, we expect BSD sales to be flat to down slightly versus last year and operating profit to be flat versus the second quarter, excluding nonrecurring items, and up versus prior year as we continue to capture operational improvements.

I'll now turn the call over to Charlie to discuss his second quarter 2011 results for the International business. Charlie?

Charles Brown

Thanks, Steve, and good morning. The International division reported second quarter 2011 sales of $827 million, an increase of 6% compared to the prior year in U.S. dollars and a decrease of 5% in constant currency. Excluding the revenue impact from our recent portfolio optimization activities, the constant currency sales were down 1% versus the same period a year ago. As a reminder, these activities include the negative impacts in divesting our businesses in Japan and Israel and deconsolidating our joint venture in India late in 2010 and, of course, the positive sales impact from acquiring Svanströms in Sweden during the first quarter of 2011. As I speak to year-over-year sales comparisons, please note that I will do so in constant currency.

Geographically, our sales results were mixed across Europe. Sales in France were relatively flat compared to the prior year, while the U.K. and Germany reported small declines in sales. Our businesses in Asia reported high single-digit growth in the second quarter, excluding the prior year sales of both Japan and India.

In the Contract channel, our European business continued to report positive sales growth from the second quarter. The Contract business performed well in France, Germany and the U.K., while we recently took a large contract with the Scottish government and illustrated our leadership position in that region. In addition, our Contract business in Asia again reported double-digit sales growth, excluding these businesses I mentioned earlier.

Second quarter sales in the Direct channel were lower than a year ago. We are happy with this performance and addressing it with some of the initiatives that I'll discuss later.

For the Retail channel, sales in the second quarter grew at a low single-digit rate compared to prior year, excluding the 2010 sales from our divested business in Israel and our first quarter 2011 acquisition of Svanströms. France, our largest retail business in Europe, reported -- continued to report positive sales growth in the second quarter.

The International division reported operating profit of $13 million for the second quarter of 2011 compared to $19 million reported in the same period last year. Excluding $6 million of charges related primarily to our business restructuring activities, adjusted operating profit was $19 million in the second quarter of year 2011 or flat to prior year. Both gross profit and operating profit margins were relatively flat versus the year before. The negative flow-through impact of lower sales is offset by the improvement in operating expenses in the second quarter. Excluding the impact of our portfolio actions, operating expenses for our existing businesses were down year-over-year. The benefits we are realizing from our restructuring activities have allowed us to invest in expanding our sales force and rebranding Viking in Europe without increasing our cost base.

Although the results for Office Depot de Mexico are currently not consolidated, it is important that we provide an update on the joint venture's performance. In the second quarter of 2011, Office Depot de Mexico reported sales of $272 million and an income of just over $14 million. Our share in the income is approximately $7 million and is reported in miscellaneous income in our income statement. During the second quarter of 2011, we also received a cash dividend from our joint venture partner totaling approximately $25 million. We remain extremely pleased with the performance of this joint venture and continues to be with us a potential platform for additional growth in Latin America.

On the first quarter earnings call in April, I mentioned that one region in Europe was less successful in passing along higher paper cost in a timely manner, and that region accounted for more than the total year-over-year profit decline. We took decisive action in that region to increase the level of resources and modified our strategies to improve its performance going forward. Although this region continued to negatively impact the division's operating profit by over $10 million in the second quarter versus prior year, we are encouraged that we are making progress and expect to show improvement by the fourth quarter of this year.

Turning to our initiatives. We continue to concentrate our efforts on implementing our strategic plan to enhance sales and drive overall profitability in the International business. Let me update you on 3 of these initiatives.

First, the portfolio optimization strategy we discussed over the past few quarters is producing the results we projected and achieved 2011 benefits to-date of $8 million. We believe that we have additional opportunities to strengthen the overall international portfolio, such as an expansion into Latin America, and we'll continue to review our options.

Secondly, we're making progress on the business restructuring and continuous improvement process initiated in Europe during the fourth quarter of 2010. These initiatives reduced SG&A costs in the second quarter by $10 million, and we continue to find opportunities to enhance our current processes and leverage our resources, enabling us to further reduce our overall cost structure.

And finally, we remain focused on winning new small- to medium-sized business customers or SMB. We launched the rebranding of Viking in May in the U.K. and Germany to drive SMB growth and improve our competitive positioning within the Direct channel. The Viking marketing effort to drive traffic was successful, but we experienced [indiscernible] transitional difficulties in the U.K. and are looking to resolve those at the moment.

So in summary, the International Contract and Retail channels continued to perform well in the second quarter, and we are pursuing opportunities to profitably grow our Direct channel. As we look forward, we will continue to carry out our strategic initiatives to properly increase sales and reduce our costs.

In regard to our third quarter outlook, we expect our sales in constant currency to be down slightly on a like-for-like basis versus the prior year and operating profit, excluding charges, to be flat versus prior year.

I'll now turn the call over to Mike, who will review the second quarter 2011 financial results in more detail.

Michael Newman

Thanks, Charlie. I'd first like to give you an update on our restructuring actions and benefits.

In the second quarter of 2011, we reported $20 million of restructuring-related charges in other costs intended to improve efficiency and benefit operations in future periods. These charges included $12 million related to the store closures in Canada, $6 million for European process improvements and $2 million for business process improvements at the corporate level.

Looking at the remainder of 2011, we anticipate an additional $30 million in charges primarily related to global process improvements and cost reductions. By quarter, we're projecting approximately $15 million in both the third and fourth quarters. The full year 2011 charges should total approximately $60 million, and the negative cash impact from these charges could be in the $50 million to $60 million range and relate mostly to severance and facility closure costs.

I'll now review the benefits from both the restructuring actions and our previously announced business process improvement activities. In the second quarter of 2011, we realized about $20 million in gross benefits, mostly from International division restructuring activities. After some reinvestment in our business, net P&L benefits in the second quarter were approximately $8 million. As a reminder, we anticipate reinvesting about $40 million to $50 million of the $80 million to $90 million in projected gross benefits back into the business in 2011.

Although the net benefits did not significantly impact our second quarter EBIT, we still anticipate the full year 2011 net benefits to be more second-half weighted and in the neighborhood of $40 million to $50 million. By quarter, we're projecting approximately $15 million in the third quarter and $20 million in the fourth quarter. As previously mentioned, the P&L benefits expected from the business reinvestments are not built into the projected benefit stream.

Turning to our second quarter results. The effective tax rate for the second quarter of 2011 on a reported basis was 27%. It is likely that the effective tax rate on a reported basis could exhibit significant variability throughout the course of the year due to change in income across jurisdictions. The effective tax rate on our earnings adjusted for charges dropped to 4% for the second quarter. The adjusted rate is lower than the reported rate because it removes charges without tax benefits that are in the GAAP calculation.

For the third quarter, we protect about $5 million in cash taxes. I should also note that we may have a noncash tax benefit in the third quarter. As background, in past years, the company has entered into statute extension agreements with certain taxing authorities to facilitate resolution of disputed items. The extension expired on June 30, 2011, for certain open years and accrued uncertain tax positions and related interest costs. We are assessing this expiration and recently enacted legislation and, depending on the results of this assessment, may reverse as much as $96 million of combined tax and interest accruals during the third quarter. For the full year, we still estimate that we will pay a total of $15 million to $20 million in taxes on both a booked and cash tax basis, excluding any discrete items.

Taking a look at cash flow. We are seeing an atypical profile of free cash flow by quarter in 2011. We ended the second quarter and first half of 2011 with an $85 million and $208 million use of free cash flow, respectively. I'll explain the dynamics of this cash use in the first half and then explain the drivers of cash generation in the second half of 2011.

During the first half of 2011, cash used by operating activities totaled $148 million. This use of cash primarily reflects changes in working capital, including an increase in inventory, the normal cash flow timing of bonuses and other long-term incentive payments and other expenses accrued in prior periods and lessened the decrease in receivables in the first half of 2011 compared to the same period last year.

The increase in inventory reflects an early build-up of direct import inventory for Back-to-School, heavier inventory of notebook computers and forward buys of products to provide a cushion for supply chain challenges in Japan. The build of direct import inventory is impactful because it generally requires payment earlier in the shipping process. The slowdown in computer sales in North America Retail division that occurred late in the second quarter also resulted in an increase in inventory that was not offset by corresponding increases in accounts payable. If we look at the second half of 2011, we anticipate nearly $120 million of working capital improvements as we sell-through the direct import and forward-buy inventories and trade payables return to normal levels.

Additionally, we expect to see $115 million to $120 million of cash generation in the second half from non-trade payables and other accrued expenses reflecting the normal invoicing cadence of non-trade payables and an increase in accruals related to bonus and long-term incentive accruals.

If we look at full year 2011, we continue to expect to generate $25 million to $35 million in free cash flow. The relevant flow components are as follows: a full year EBIT projection in the $100 million to $110 million range; a negative cash impact from restructuring charges of $50 million to $60 million; interest expense of $70 million; cash taxes of about $20 million; and we expected to pick up $50 million to $60 million in cash with 2011 capital expenditures in the $150 million to $160 million range netted against depreciation and amortization in the range of $210 million to $215 million; and finally, a working capital benefit for the total year of $25 million resulting from the second half improvements I just outlined.

Turning to our liquidity. We ended the second quarter with $374 million in cash and $766 million available from our amended credit agreement for a total liquidity of over $1.1 billion. We did have borrowings of about $45 million in Europe under the amended credit agreement at the end of the second quarter, and this was related to our acquisition of Svanströms in Sweden in the first quarter.

During the second quarter, we recorded a dividend on our convertible

preferred stock of approximately $9 million, which was paid in cash in July. On June 20, we entered into an amended merchant service agreement with Citibank, the bank that previously provided and administered our private label credit card program. The agreement extends the arrangement for 5 years through September 2016, eliminates recourse to the company for losses, appends portfolio life determination, [indiscernible] the overall theme and modifies other terms and conditions. As a result of this amendment, a previously established unfunded bad debt accrual of approximately $8 million was reversed during the second quarter of 2011. The revision is included in the discrete items impacting operating profit for both North American Retail and BSD, as described by Kevin and Steve. From a business perspective, extending this agreement was very important given that both individuals and small businesses that have the private label credit card for multiple years are some of our very best customers.

Looking at the outlook. For the third quarter, we expect total company sales to be roughly flat versus the prior year and EBIT, excluding charges, to be up compared to last year.

With that, I'll now turn the call back over to Neil.

Neil Austrian

Thanks, Mike. In closing, I have witnessed the renewed energy and excitement of all the others within the company, and I'm confident that we have begun the process of returning to the profitability of prior years. We have focused the company on a few key initiatives, some of which will begin paying off this year, while others will reap benefits in 2012 and 2013. What has given me encouragement is the fact that our associates have all signed up for this focused approach, and we will continue to make the changes needed to create opportunities from proved financial performance. We understand that we're on a journey, the benefits of which we'll take time to fully realize.

Before we start the Q&A, I wanted to mention that the Back-to-School season also marks the most active time for the Office Depot Foundation's Backpack Program. The foundation will hold 25 events across the U.S. during Back-to-School and give children over 350,000 backpacks filled with school supplies to help them start school with the tools they need to succeed. Since 2001, the Office Depot Foundation has helped over 2.5 million children begin the school year with confidence, and I'm very proud of the great work they do and the many lives they've touched.

Brian Turcotte

Thanks, Neil. Operator, we're now ready to take questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Colin McGranahan.

Colin McGranahan - Sanford C. Bernstein & Co., Inc.

It's Colin McGranahan at Sanford Bernstein. First, I just wanted to ask about gross margin. Obviously, a pretty good performance in North America. Can you give us a little bit more color and insight as to what some of the discrete drivers were there both in Retail and in BSD?

Kevin Peters

Sure, Colin. This is Kevin, on the gross margin side for Retail. It really was a couple of things. One was being less promotional than we historically have been with regards to rebates and coupons. And I think the second piece was really doing a much better job and having lower levels of clearance in things like supplies, tech and peripherals. Those were the 2 principal drivers in Retail.

Steven Schmidt

Yes, Colin. Steve, on the BSD side. It was similar to what Kevin talked about. On the Direct side, it was really taking a hard look at promotional spending in addition to mix of what we were selling by channel. And then on the Contracts side, we talked in 2010 about really focusing on productivity and taking a number of expenses out of the base of the Contract business. Those have proved to be good decisions, and we're starting to see the fruits of that -- of those initiatives in 2010 in the 2011 business results.

Colin McGranahan - Sanford C. Bernstein & Co., Inc.

Okay. And if I could just follow up on that. Sounds like, last quarter, there was some concern about competitive intensity, inability to pass through price increases not just in paper but in other products. Given this gross margin performance, can you just comment on what you're seeing competitively both in Retail and, I think more importantly, in the Contract business, as you're going out to retain and win new contracts?

Steven Schmidt

Yes, let me start off on the BSD side of the fence. First of all, the price increases and those issues you talked about, I believe, were on the International side, not in North America. But relative to the competition that we're seeing out there at this point, I would say that, nothing abnormal. I think it continues to be highly competitive with all of the players in this space. But I would say at this point, there's nothing abnormal to call out. We continue to see some irrational behavior from time to time. But this is a tough market, very competitive, and we're all fighting for market share.

Colin McGranahan - Sanford C. Bernstein & Co., Inc.

And then a final follow-up on gross margin just in terms in Retail. On the negative side, how should we think about the excess laptop inventory in terms of clearance going into Q3? And then it sounds like that you've made a lot of progress on direct sourcing. I think it was up 300 bps in 2Q, and it sounds like it's even growing, given the forward buy of direct sourcing for Back-to-School. Can you talk about how those 2 dynamics might work and solve that going forward?

Kevin Peters

Yes, we were pleased with penetration improvement both in direct importing as well as private brand. We saw big changes in year-over-year penetration levels in both those categories. And certainly, contributed positively to the margin improvement in Q2. So our expectation, as we've talked about in the past, is that we'll continue to step on that pedal and see if we can drive further levels of penetration in both private brand and direct import. With regard to the laptop, again, we picked up share in laptop in OSS, but it was really the tail of 2 sides of a quarter. The laptop business drove comps in the first part of the quarter and got softer than we've ever seen in the tail-end of the quarter, so we did carry inventory over. Our expectation is, though, and just looking at sales here over the last few weeks, is that the carryover of laptops won't put any pressure on us in Q3, though.

Michael Newman

Colin, it's Mike Newman. The guidance I gave on the second half of $120 million of working capital improvements, about $40 million of that's inventory. And so while that's not a small amount on a year-end balance and through a compy of $1.2 billion, to Kevin's point, we should be able to work through that pretty easily.

Operator

Our next question comes from Christopher Horvers.

Christopher Horvers - JP Morgan Chase & Co

Chris Horvers, JPMorgan. So just some clarification questions on the guidance. So you said EBIT of $100 million to $110 million for the year, I'm assuming that's GAAP. So if we adjust for the charges in the first half...

Michael Newman

No, that's exit charges. That's exit charges.

Christopher Horvers - JP Morgan Chase & Co

Because all that -- all the charges are noncash?

Michael Newman

Well, there are some cash charges. But we gave EBIT guidance exit charges of $100 million to $110 million, and then we had cash restructuring of $50 million to $60 million.

Christopher Horvers - JP Morgan Chase & Co

Right. So year-to-date, so you're talking like $70 million to, what, $70 million to $80 million of EBIT in the back half of the year then?

Michael Newman

Including charges? Yes. Based on those 2 sets of numbers, you're going to be in the low-end, 50 on the high ends. Yes, somewhere in -- yes, close to that.

Christopher Horvers - JP Morgan Chase & Co

Right, because it would be $100 million to $110 million, and you've got $30 million so far, right? So that's $70 million to $80 million, okay. Right, right, right. And so as you think about the tax rate for the year, I understand that $15 million to $20 million in cash taxes for the year. But the tax rate in 3Q, maybe you could just clarify what -- how you're thinking about what the GAAP tax rate might be in the third quarter?

Michael Newman

Yes, it's real difficult because of both earnings mix, as we said in the script. I think the best thing to do is that, we've said that, for the year, we expected cash taxes to be about $20 million, and I think, through the first half, cash taxes are probably a little bit less than that. So I would model cash taxes for the year, it's really going to be hard especially if we have this drawback of the deferred tax assets that we talked about in the script of $90 million to $100 million. It's going to -- it's impossible to talk about a GAAP tax rate with any certainty.

Christopher Horvers - JP Morgan Chase & Co

Okay, fair enough. And then so you -- Kevin mentioned, in the PC category, you gained share in a -- if that category was down in the back half, it seems like the industry is just, overall, still tough PC sales. Was there anything discrete that drove the drop-off in PC sales in the back half of the quarter? Did you pull back on promotions? Was it tablets coming in? What exactly was the driver?

Kevin Peters

Yes, Chris, this is Kevin. To be perfectly honest with you, if we knew that answer, we'd feel a lot better. But we've picked up share in OSS. I think there is some indication that in Retail in general, that there was kind of a remixing of share but nothing specifically detrimental to us. We did not change our promotional cadence. We did not change our mix. There just seems to be a drop-off in overall demand for laptop. I think there was some evidence of that as you look at the chip makers when they announced earnings, and there was some softness particularly in U.S.-based sales versus global sales. So I think it ended up just working itself through our channel and specifically with Office Depot. But the other thing I would add is that, even if you adjust for tablets, not only the tablets that are carried in our offering but the tablets that are carried by or that are produced by Apple and even the MacBook, it still doesn't explain the drop-off in sales.

Christopher Horvers - JP Morgan Chase & Co

Okay, and then fair enough. And just one final question for Neil. I want to follow up on the departure -- the Board departure. I know you mentioned he was just going through a different opportunity, but he's been around the company for such a long period of time, and it does seems an abrupt departure from one perspective. And then from the other perspective, do you think that his departure is a loss of guidance from the Board?

Neil Austrian

Basically, what happened is Dave decided to become a senior advisor Peter J. Solomon Company, an investment banking firm with whom our company has done and probably will do business. And given all the new reasons in terms of corporate governance, Dave actually resigned also from all his public Boards: Ryder, Dick's Sporting Goods and Office Depot. Given that Dave and I have become very good friends, I fully expect to be able to tap into his expertise going forward, and I don't see that really changing.

Operator

Our next question comes from Matt Fassler.

Ryan Brinkman - JPMorgan

This is actually Ryan Brinkman for Matt Fassler at Goldman Sachs. Could you speak to the impact of changing mix on gross margin improvement versus potential various other factors such as a change in markdown activity?

Michael Newman

Yes, I'll jump in, this is Mike Newman. In addition to the things that we mentioned in North America Retail and BSD in the second quarter, we still -- we have seen nice mix improvements from our services. Particularly as our Tech Depot businesses start to grow, we've seen nice mix impacts there. So I won't quantify how much of the margin improvement in each business was mix-driven and how much was promotions, but we got very nice contributions from both.

Ryan Brinkman - JPMorgan

Okay, that's great. And then could you also maybe talk about the trend of higher inventories, lower payables and the consequent increase in that, on the inventories?

Michael Newman

Yes, it's, as I said on the script, it's an atypical profile cash flow use for us, and we ended the first half in inventories probably about $50 million round numbers higher than we would have liked. That was direct import inventories, it was laptop inventories. We had some prebuys and some Japan supply chain issues. We actually had a couple prebuys with vendors that took advantage of some prices. And we didn't get any support on the AP side because we ended up with this excess inventory DI [ph] because of the pipeline tech, because of the terms tend to be more rapid. We got real interesting double whammy dislocation on cash flow, which I expect to right itself by year end. If you look at our balance sheet and look at our AP-to-inventory ratio, for the end of the second quarter, we were in the mid-70s, 76%. Now, this business is run in either the mid-80s to the 90s for the last year. We've not had any changes with vendors' term lines, that's been constant. But that's where you really see this. And in addition to taking the inventories down by year end, as Kevin mentioned, we expect to see a more reasonable mix in the AP inventory and get back into that mid-80 range. And so when we talk about the working capital guidance for the second half of $120 million, about $40 million to $50 million of that's inventory, and the balance is really seeing the payables go back to normal levels and get the support at year end from payables that we normally see. So we've studied this a lot. We're confident that's what's going to happen, and it's a very unusual occurrence for us to see that kind of mix at the end of the first half.

Operator

Our next question comes from Brian Nagel.

Brian Nagel - Oppenheimer & Co. Inc.

It's Brian Nagel from Oppenheimer. Couple of questions. First on gross margin. Recognizing others have already asked about it, but just to be clear. So we look at the income statement, we get about a 90 basis point improvement year-over-year. How much of that is a true improvement versus an effective onetime factors?

Michael Newman

I would say most of it's operational. We might have had a small amount that was one-timers, but most of it's operational for all the reasons we just articulated in the last 2 questions.

Brian Nagel - Oppenheimer & Co. Inc.

Okay, okay. And then on the computer issue. You talked about the weakness late in the second quarter. Have you seen a change in trend early in Q3?

Kevin Peters

It's a good -- Brian, this is Kevin. I think the way to answer that is the first part of July continued to exhibit the softness that we saw in June. Now part of that was the July 4 holiday laughing over the July 4 holiday, which I think added some softness at least on the Retail side. That being said, the second half of July has exhibited signs of returning the laptop sales to more of the -- more traditional levels.

Brian Nagel - Oppenheimer & Co. Inc.

Okay. And then finally, you called out in your press release and then you alluded to it in your prepared remarks as well, just the maybe a better trend in your -- the North American BSD division x government. Was there a -- did you see a significant turn of business there in some of the customer activity? Or was that just more of a stabilization, as you talked about before?

Neil Austrian

Yes, Brian, I would say it's really more a stabilization, as we talked about, discretionary spending by our key customers. We aren't seeing a significant improvement but more of a stabilization trend that we have seen over the last few quarters. We continue to manage mix. The fact that we actually grew SMB slightly helps from a margin perspective, but that would be the majority of what's driving that.

Operator

Our next question comes from Kate McShane.

Kate McShane - Citigroup Inc

Kate McShane, Citi Investment Research. You had mentioned that one of your initiatives in the delivery business was to reduce overhead and supply chain expenses. And just wondered if you could walk us through what there is left to do there?

Steven Schmidt

Kate, Steve. As we look at supply chain, there's numerous opportunities as we look at AOV and MOV. You look at things like route density, and you look at sourcing of goods and services from a direct import standpoint and how we manage the overall mix of business. So like everyone, we're always looking for productivity, and we believe that there is significant room, yet still, to improve our overall cost structure.

Kate McShane - Citigroup Inc

Okay. And if I could switch gears a little bit. Last quarter, there seemed to be a significant amount of price competition in the international market. Can you just comment on the promotional environment internationally, currently?

Charles Brown

Yes, Kate, this is Charlie. The issue last quarter was we were still playing catch-up on some of the price increases that we saw late last year. This quarter, we were on top of it all the way back, and our gross margins in the International division were essentially flat year-over-year, which was an improvement versus Q4 last year and Q1 this year. So it's still is quite competitive. But I think it was really more of an issue of us getting on top of the price increases as they came from [ph] the paper suppliers.

Operator

Our next question comes from Brad Thomas.

Jason Campbell - Macquarie

Yes, this is actually Jason Campbell sitting in for Brad, KeyBanc Capital Markets. You said that the small and mid-sized business was up, I believe you said, for the first time since 2008. I was just wondering if you can give us some of the drivers. Was it more ticket or customer acquisition with that?

Neil Austrian

Yes, I mean, SMB continues to be a focus for the company, and we continue to improve in a number of areas. First of all, from a sales standpoint, a coverage standpoint, we continue to add efficiency and effectiveness through our TDMs and TDRs, the people that are primarily calling on the SMB segment. We continue to focus on our TAM organization, our telephone account management, which deals with our smaller customers in the SMB space to improve the efficiency of that operation, so we continue to make progress there. In addition to that, from a marketing standpoint, as we think about our contact strategy and how we market into the SMB segment, we've made improvement there also. So those are probably the 3 main drivers as we look at SMB.

Jason Campbell - Macquarie

Great. And then the only follow-up I had was, you've been talking recently about reducing your store size. You said you've, I believe, remodeled a handful of stores and reduced it by 20% to 30%. How was that in terms of where you plan to be? Are you kind of ahead? And are you finding landlords who are willing to work with you?

Kevin Peters

I think, Jason, as we've talked in the past. We have about 100 leases or so that come up for renewal each year. We view those each as an opportunity to downsize and remodel the stores. We have a plan that takes us out through 2013 to get after that, and we are on track with a plan right now. But you can see it in the property cost -- occupancy cost improvements that we've had already this year and a little bit last year.

Operator

Our next question comes from Dan Binder.

Daniel Binder - Jefferies & Company, Inc.

It's Dan Binder with Jefferies. A couple of questions for you. First, so this position to be more disciplined on promotion as well as reduced advertising obviously is generating some profit improvement here in the short run. I guess, what are you -- how do you view the risk of those 2 actions potentially having a tail on it that results in slower sales growth?

Kevin Peters

Dan, this is Kevin. I think the actions that we've taken this year have been deliberate. I don't know that we necessarily think of them as short-term. I think, essentially, we've been much more strategic and thoughtful about our promotional activity in the business, particularly around products that don't exhibit a relationship between price and volumes. So those that probably are more inelastic in their demand patterns than elastic. And so we've really tried to be smart about where we invest our promotional dollars in terms of acquiring and retaining customers using that promotional leverage. So I think we've certainly reduced the level of promotional activity that we're doing particularly on items that we don't think we're getting the volume lift. With regard to advertising, we've also taken, I think, a more thoughtful approach, and we've looked at our advertising spend across all the vehicles that we have and where we have a vehicle that we think didn't give us a reasonable return on investment. We've repurposed those dollars into other activities. An example would be in some of our strategic initiatives. So again, we think that's a positive, that's not a negative.

Daniel Binder - Jefferies & Company, Inc.

And then if you could give us an update on where your, on absolute terms, where your private label and direct import penetration is today and what the opportunity maybe over the course of the next year or two?

Kevin Peters

Sure. We saw about a 300 basis point improvement in North American Retail and direct import penetration and close to a 450 basis point improvement in private brand penetration year-over-year. We're -- that certainly had a part to do with our margin improvement in North American Retail. And as we mentioned in the past, we think that there are continued opportunities to drive further penetration in both direct import and private brand. I think the same would be true on the BSD side of the house.

Daniel Binder - Jefferies & Company, Inc.

So in absolute terms, can you give us an idea where that level is today?

Neil Austrian

I think we'll just leave it at that.

Daniel Binder - Jefferies & Company, Inc.

Okay. Finally, if you could. You talked a lot about restructuring and business process improvement. So actually can you give us maybe a couple of examples on the business process improvement side in terms of -- maybe pick a couple of the big items that you think are making up a big contribution to the change in the profit profile?

Michael Newman

Yes, this Mike Newman. I think you know the story. The things we've worked on to date, that we're having good success on in direct expenses. We've looked at some financial processes inside of finance. We've had this business process improvement team in place for over a year now. They're becoming part of our fabric. We're starting to work on the things we're investing, the savings into this year, the $40 million to $50 million. We're looking at a number of different initiatives. We're looking at pricing effectiveness. We're looking at promotional effectiveness. We're looking at parts of our business. We're looking at our direct import supply chain as we become more penetrated there, where you can see some of the pressures that's creating on cash flow. We're looking at opportunities there. We've got a list of 10 to 15 items internally in the business. We've talked to you externally about some of them, and in the next few quarters, we'll be talking more with some more concrete examples. But Kevin mentioned in-store customer experience, he mentioned occupancy, and he talked about the benefits from those. We're starting to really get our heads around some significant numbers from these initiatives. So I'm encouraged that we'll continue to see the margin expansion that you saw -- you're seeing today not being short lived, not being one-timers, not being promotional for the sake of short-term results, but we'll be able to sustain this going forward.

Operator

Our next question comes from Mike Baker.

Michael Baker - Deutsche Bank AG

It's Deutsche Bank. So 2 questions. One, you've seen some improvement in sales here. How much of that do you think is starting to see some of the year-over-year growth in employment level, particularly white-collar employment level is starting to flow through into your business and versus how much you think is market share gains? And then my second question is on store closures. Kevin you had alluded to having a plan in place through 2013. Can you remind us what -- have you talked about or could you now talk about what do you expect your total square footage to be in 2013 versus where it is now?

Neil Austrian

This is Neil. On the employment issue, we haven't seen any change at all. In fact, it's still going down, and the number of the white-collar people in terms of employment, who have been out of work for more than 6 months, continues to increase. So that has not been a positive impact on our business at all at this point.

Michael Baker - Deutsche Bank AG

Well, isn't clients up -- isn't the year-over-year number of white-collar employed people up year-over-year when we look at the monthly data that's come out?

Neil Austrian

We haven't seen that in the SMB sector, which is our key. You'll see it in manufacturing, and you've seen it in some of the large financial institutions. We don't see it in terms of the key customer base that we're focused on.

Michael Baker - Deutsche Bank AG

Okay, fair enough.

Kevin Peters

I think, Mike, on your first question, again, it goes back to the 100 or store -- 100 or so leases that come up for renewal each year. We try to auction as many of those as we can to reduce the size of the store footprint today. Our average store footprint sits at about 24,000 square feet. When we're successful in downsizing, we can reduce that square footage by about 30% and, depending on the terms of the deal, get some flow-through benefit in terms of reduced rent not always proportional to the downsized -- of the actual store square footage. And then where we can't get a downsize and a remodel, we're actively involved in trying to just reduce the overall rent even though the square footage might be the same. So our real goal is to get as many stores remodeled as we can and flow-through that benefit and, where we can't, flow-through the benefit of reduced occupancy cost on the balance of the stores. And we really haven't called out a net number in terms of our goal, in terms of total square footage of our store base.

Steven Schmidt

And Mike, this is Steve. I would just add regarding market share and where we sit particularly on the Contract side of the business. We're actually retaining our medium to large customers right now at very high levels that we haven't seen, so I'm very pleased with that. And we are gaining share, and we have won a lot of new business, and we continue to retain our existing customers at very high rates. So those are really contributing to some of the momentum that you're seeing.

Michael Baker - Deutsche Bank AG

Okay. So it sounds more like share gains than anything else, in your view?

Steven Schmidt

Yes.

Operator

Our final question comes from Joe Feldman.

Joseph Feldman - Telsey Advisory Group

Telsey Advisory Group. A kind of some longer-term question sort of for you, Neil. First is, I was just kind of curious where you've been spending most of your time lately and, maybe, which business unit is getting the most of your attention. And then also if you guys, as maybe a team, could just kind of share your vision for the longer-term operating margin potential? I know, in the past, you've talked about getting back to that 3%, 4% where you have been. I'm sure that's still a goal, but any sense of timing, how soon you'd like to be there and just kind of how you're thinking about the longer term?

Neil Austrian

Sure. I've been spending my time primarily in North America because we've been doing extremely well internationally, and a large part of that has been thinking through organizational changes and people changes that we needed to make. I think I'll continue to be spending a larger part of my time thinking about in working with Steve and Mike and Kevin on the corporate strategy in terms of where we go domestically. I still see us getting to that 3-, 4-plus-percent by the end of 2013. And that's the goal we've set, and everybody in the company is clearly aware of it. The initiatives are all focused on that. And it's not -- that goal does not have to have significant revenue increases for us to get there.

Brian Turcotte

Sorry to go on overtime here, but this concludes our webcast and conference call this morning. Thank you very much for participating. And I'll be available to take your calls later today. Have a great day.

Operator

That does conclude today's conference. Thank you for participating. You may disconnect at this time.

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