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Office Depot (NASDAQ:ODP)

Q3 2011 Earnings Call

October 25, 2011 9:00 am ET

Executives

Brian Turcotte - Vice President, Investor Relations

Kevin Peters - President of North America

Michael D. Newman - Chief Financial Officer and Executive Vice President

Unknown Executive -

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

Analysts

Jeremy Brunelli

Joseph I. Feldman - Telsey Advisory Group LLC

Joscelyn MacKay - Morningstar Inc., Research Division

Emily E. Shanks - Barclays Capital, Research Division

Daniel T. Binder - Jefferies & Company, Inc., Research Division

Christopher Horvers - JP Morgan Chase & Co, Research Division

Alan M. Rifkin - Barclays Capital, Research Division

Michael Lasser - UBS Investment Bank, Research Division

Ivan Holman

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Colin McGranahan - Sanford C. Bernstein & Co., LLC., Research Division

Operator

Good morning, and welcome to the third quarter 2011 earnings conference call. [Operator Instructions] At the request of Office Depot, today's conference is being recorded. I would 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; and Kevin Peters, President of North America.

Before we begin, I'd 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 is 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 summarize Office Depot's third quarter 2011 results. Neil?

Neil R. Austrian

Thank you, Brian and good morning. Office Depot's third quarter 2011 sales totaled $2.8 billion, down 2% compared to our third quarter results in 2010. Excluding sales related to previous portfolio actions, constant currency sales in the third quarter of 2011 decreased about 3% versus prior year. The company reported net earnings after preferred stock dividends of $92 million or $0.28 per diluted share in the third quarter of 2011 versus $32 million or $0.12 per share in the same period one year ago. Third quarter 2011 results included approximately $6 million of charges, primarily related to restructuring activities and actions to improve future operating performance, as well as the benefit from the reversal of $99 million of combined tax and interest accruals that we had mentioned in our second quarter earnings webcast.

Excluding these charges and benefits, the net loss after preferred stock dividends would have been about $700,000 or $0.00 per share. I should note that our third quarter 2010 reported earnings also included significant tax and interest expense benefits that positively impacted earnings by about $0.14 per share.

Total company gross profit margin increased about 150 basis points in the third quarter of 2011 compared to the prior year. This was the sixth quarter out of the past 7, that we have increased total company gross margins year-over-year. The gross margin improvement this quarter was driven primarily by increases of 240 basis points in North American Retail and 110 basis points in North American Business Solutions. The International division's gross profit margin increased about 30 basis points during the third quarter of 2011.

Total company operating expenses adjusted for charges, foreign exchange, acquisitions and dispositions decreased by $1 million compared to the third quarter of 2010. September year-to-date operating expenses adjusted for charges, foreign exchange, acquisitions and dispositions decreased by $20 million compared to prior year. EBIT adjusted for charges was $30 million in the third quarter of 2011 compared to $20 million in the prior period. The significant year-over-year improvement was attributable to strong results in both North American Retail and Business Solutions.

I'm pleased with the traction we are getting in our North American business despite a lackluster U.S. economy. The successful execution of our key business initiatives is beginning to move the needle. Although the international team is also making progress executing its key initiatives, third quarter results were weaker than expected and I'll review them later in the call.

I'll now ask Kevin to review our third quarter 2011 performance in North America.

Kevin Peters

Thanks, Neil and good morning. In the North American Retail division, third quarter sales were $1.2 billion, down 4% from the prior year. Comparable store sales in the 1,108 stores that have been open for more than one year decreased 2% for the third quarter 2011. The declining comparable sales of computers and related products contributed significantly to the overall sales decline. This decline was partially offset by a strong performance in supplies, which comped positively for the first time since 2006. If we exclude the weak technology sales in the third quarter, North American Retail's comparable store sales would have been slightly positive, as sales increases were also reported in Back-to-School essentials, Tech Depot Services and Copy & Print Depot.

In fact, Tech Depot Services and Copy & Print Depot comped positively for the seventh consecutive quarter while furniture sales in the third quarter were essentially flat versus the prior year. Retail's average order value was slightly negative in the third quarter and customer transaction counts declined approximately 2% compared to the same period last year. The decline in total sales for the third quarter also reflects the closing of stores in Canada during the second quarter of 2011.

Our goal to increase direct import of products continues to go well, direct import penetration in the North American Retail division was at 14% in the third quarter, a 240 basis point increase versus the same period last year. Our North American store count at the end of the third quarter was 1,132 stores. During the quarter, we opened 3 new stores and closed 2. We also remodeled 8 stores and relocated 3, successfully reducing the square footage in 9 of those 11 locations by over 30% on average.

North American Retail reported operating profit of $42 million in the third quarter compared to $30 million in the same period of 2010. The increase reflects 240 basis points of gross margin improvement, including improved product margins from a higher sales mix of supplies and lower mix of technology products, better management of pricing and promotions and lower property costs. These benefits were partially offset by the negative flow-through effect of lower sales and higher operating expenses incurred to fund our key initiatives during the quarter.

We're very pleased with our Back-to-School performance this year. We had low single-digit increases in sales and gross margin compared to the prior year and $1 share gain in school supplies as measured by a third-party research firm.

We attribute the improved performance this year to a number of factors including marketing our Back-to-School effort earlier compared to prior years and improved in-store merchandising and promotion. We continued to implement our key initiatives to drive profitable sales and reduce costs for the North America Retail division during the third quarter. I'll now update you on our progress with 3 of those key initiatives.

First, I'm excited to tell you we are moving into the rollout phase of our plan to improve the customer in-store shopping experience. Our pilot stores in the 2 test markets consistently outperformed our control stores and we have more than doubled the percent of pilot stores with positive comp sales. Our plan is to rollout the new service model to over 300 stores by yearend and complete the remaining fleet in 2012. Our second initiative is to focus on improving the sales productivity of our stores. This includes remodeling about 30 to 40 traditional stores into our N2 format in 2011 and reducing the average store size wherever possible. I'm pleased with the progress being made. We have reduced the average store size with remodels and relocations by approximately 30% over the past 3 quarters.

In addition, we have lowered our occupancy costs by about $18 million September year-to-date, and project savings of about $20 million by yearend. One of the store relocations this quarter was into our new 5K format, raising our total to 6 locations. To date, the downsized 5K stores have retained over 90% of the legacy sales with roughly half of the SKUs and a fraction of the selling area. Based on the results from these locations thus far, the 5K will be one of our 2 store formats we will utilize going forward. In fact, we plan to open one of these 5K stores within a short commute from the Manhattan area in December, so stay tuned. And then finally, our third initiative is to pursue additional opportunities to improve margins, including pricing optimization and increasing promotional effectiveness. We have made nice progress in this area and Mike will review the benefits later in the call.

In summary, we're pleased with our results in the third quarter and believe that we have stabilized the business. We are excited about our initiatives and are certain that they are the keys to increasing profitability of the North American Retail division as we move forward. In regards to our fourth quarter outlook, we expect our year-over-year same-store sales rate to be consistent with the third quarter rate of minus 2% and operating profit to be up versus prior year, including the impact of the 53rd week.

Now turning our attention to the North America Business Solutions division, or BSD. Third quarter 2011 sales were $821 million, a 2% decrease versus the same period last year. BSD's average order value was flat to last year and customer transaction counts were lower.

While discretionary spend appears to have stabilized, we still have not seen a significant change in discretionary purchases by our customers. Direct channel sales in the third quarter were flat versus one year ago and Contract sales declined about 3%. The decline in Contract was consistent with the decrease experienced earlier in the year from customers not retained during the January 2011 transition to our new Public Sector purchasing consortiums.

During the third quarter, we recorded an 86% sales retention rate for that Public Sector business.

Within the Contract channel, sales to large accounts and the federal government increased this quarter versus prior year. We're very pleased that we won a number of large customer bids during the quarter. However, we continue to see weakness in the state government area as these public sector customers continue to experience budgetary pressures.

Sales to small- to medium-sized businesses, business customers decreased slightly in the third quarter versus the prior year, due in part to the transition of our telephone account management organization from legacy third parties to an in-house group. We're very excited about bringing this critical sales function back in-house and believe that the move will drive high margin sales growth in the Contract channel.

Looking at our third quarter sales by product category, we did see double-digit sales growth versus prior year in Cleaning and Breakroom products while Supplies, including paper and ink and toner were lower. I should note however, that our paper sales did decline at a rate favorable to the division average during the quarter.

Third quarter operating profit for BSD was $39 million compared to $25 million from the same period one year ago. The $14 million increase reflects a 110 basis point gross margin increase, operational improvement and better expense management. Initiatives that were put in place in prior quarters to improve the division's overall profitability contributed to lower distribution, advertising and payroll expenses in the third quarter. These initiatives include eliminating certain investments in low value added or no value added areas, reducing overhead and supply chain expenses and taking a much more disciplined approach to promotions and measuring their effectiveness. We're also focusing on improving product margins. For example, we've had success converting customers to Office Depot's own branded products.

In summary, it was solid quarter for the North America Business Solutions division, lower volume was offset by improved margins in both channels, as well as by cost-containment supported by a greater level of financial discipline. In addition, we continue to win new business in the Contract channel and our Direct channel performed well, maintaining its competitive position in the market.

In regard to BSD's fourth quarter outlook, we expect sales to increase and operating profit to be down slightly versus last year, including the impact of the 53rd week. Excluding the benefit of the bonus accrual reversal recorded in the same period last year, our projected fourth quarter operating profit would be flat year-over-year.

Now before I turn the call back over to Neil to discuss the results for the International division, I would like to recognize the ongoing success of our green initiative. Many of our customers have told us that they want to better understand their green spend and they value Office Depot's commitment and unique capabilities in this area.

In recognition of this commitment, the annual Newsweek Green Ratings, perhaps the most anticipated green ratings in the world, were published last week and Office Depot was the only retailer to make the top 10 for the second year in a row. I would like to congratulate our associates on this great green achievement. Neil, back to you.

Neil R. Austrian

Thanks, Kevin, and I also offer my congratulations as well. That's a great job in an area that clearly differentiates us from our competition. The International division reported third quarter sales of $783 million, an increase of 1% compared to the prior-year period in U.S. dollars and a decrease of 7% in constant currency. Excluding the revenue impact from the fourth quarter 2010 dispositions and deconsolidation, as well as the first quarter 2011 acquisition, constant currency sales were 2% lower versus the same period a year ago.

As I speak to year-over-year sales comparisons, please note that I'll do so in constant currency. Contract channel sales increased overall with growth in both the U.K. and Germany, partially offset by weakness in the public sector in our other European countries. Macroeconomic pressures in Europe increased in the third quarter with some large banks reducing office product purchases from normal levels. Third quarter sales in the Direct channel in Europe were lower than a year ago. We continue to focus our management attention and resources on our Direct business to reverse the unfavorable trends in this channel.

Excluding sales from the division's business in Israel that was divested in late 2010, and the first quarter 2011 acquisition in Sweden, third quarter sales in the Retail channel declined modestly compared to prior year. The International division reported third quarter operating profit of approximately $19 million compared to $30 million reported in the same period last year. Excluding approximately $4 million of charges related to business restructuring actions and process improvement activities, adjusted operating profit was $23 million in the third quarter of 2011. The adjusted operating profit decline versus prior year was driven primarily by the negative flow-through impact of lower sales and the absence of earnings from the divested business in Israel, which were included in the 2010 results. Also certain pricing issues experienced in one European region during 2011 have improved but are not fully corrected. The decline was partially offset by a reduction in operating expenses during the quarter.

For the third quarter, Office Depot Mexico reported sales of $308 million and net income of $18 million. Our share of the net income was approximately $9 million from the quarter, and is reported in miscellaneous income net on the income statement.

Turning to our initiatives in the International division, we continue to concentrate our efforts on implementing our strategic plan to enhance sales and drive overall profitability. Let me update you on 2 of these initiatives.

First, the portfolio optimization strategy we've discussed over the past few quarters is producing the results we projected achieving 2011 benefits to date of $11 million. We believe we have additional opportunities to strengthen the overall international portfolio and we'll continue to review our options. And secondly, we're making progress on the businesses restructuring and continuous profit improvement initiative in Europe, as we reduced SG&A costs in the third quarter by $12 million. We continue to find opportunities to enhance our current processes and leverage our resources, enabling us to further reduce our overall cost structure.

I should note that benefits from initiatives achieved to date, have been reinvested in our businesses in an effort to address the sales pressures. In summary, the International Contract channel continued to perform well in the third 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 profitably increase sales and reduce costs.

In regard to our fourth 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 roughly flat, including the impact of the 53rd week. Our ability to maintain flat year-over-year operating profit on lower constant currency sales is due to the progress we've made in optimizing the portfolio strategy and in executing our key initiatives.

I'll now ask Mike to review the company's third quarter financial results in more detail.

Michael D. Newman

Thanks, Neil. I'd first like to give you an update on our restructuring charges.

In the third quarter, we reported $6 million of restructuring related charges in other costs intended to improve efficiency and benefit operations in future periods. These charges included about $4 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 $20 million in charges, primarily related to global process improvements and cost reductions. The full year charges should total approximately $55 million and the negative cash impact from these charges could be in the $50 million to $55 million range, related mostly to severance and facility closure costs.

Next I'd like to discuss our key business initiatives and the positive impact that they have had on EBIT September year-to-date.

Slide 12 in the earnings presentation provides details on the various components of our 9-month 2011 EBIT growth versus the prior-year period. Starting on the left side of the chart, we have realized approximately $120 million in growth initiative benefits year-to-date, mainly from the following initiatives: Approximately $40 million in benefits from pricing and promotional effectiveness; about $20 million in occupancy reductions in both our North American Retail and BSD businesses; over $40 million in reductions from indirect procurement and International business process improvements; and finally, about $20 million in cost reductions in BSD. I should note that in July, we told you that about $35 million of gross benefits were achieved through the second quarter. At that time, we did not include lower occupancy costs, BSD cost reductions and pricing and promotional effectiveness in that figure. If we include the impact from those initiatives, the gross benefits captured June year-to-date would have been about $60 million. In regard to our third quarter performance, we captured approximately $60 million more of gross benefits, primarily from lower occupancy costs, pricing and promotional effectiveness and International business process improvements. If you continue across the chart, you see that we also had approximately $110 million of offsets to the September year-to-date benefits in 3 areas.

First, we have incurred about $30 million in incremental spending in 2011 to drive these initiatives that is largely one-time in nature, including consulting fees. Second, we have also reinvested about $20 million of these gross benefits, including first, adding international sales personnel to drive small- to medium-sized business sales, investing in our domestic merchandising and marketing organizations to drive key business initiatives, investing in our Business Process Improvement organization to drive our continued focus on process improvements and finally, in costs related to increase payroll and benefits for our associates.

The third offset to these benefits is the impact of lower sales volume, which negatively impacted EBIT by over $60 million September year-to-date. To sum it up for you, excluding the lower sales volume impact, our net benefits after the incremental spending to support our key initiatives and business reinvestments totaled about $70 million September year-to-date with $40 million realized during the third quarter. We expect net benefits of about $35 million in the fourth quarter.

It is also important to note that we expect the rate of incremental spending to drive our initiatives in business reinvestments to decline as we move forward, reducing the offset and allowing us to drive more of the gross benefits achieved to the bottom line.

My final comment on this critical effort is that although we are pleased with the progress of the cost reduction initiatives to date, we need to continue to drive those initiatives that increase profitable sales across all channels as well. Cost reduction alone is not a winning strategy.

Turning to our third quarter results. The effective tax rate for the third quarter on a reported basis was a negative 139%, primarily due to the reversal of $66 million in accruals for uncertain tax positions from prior periods. The effective tax rate on our earnings adjusted for charges was 45% for the third quarter. We project paying about $11 million in book taxes in the fourth quarter and a total of $20 million to $25 million for the full year excluding any discrete items. On a cash tax basis, we expect to pay about $10 million in the fourth quarter and a total of $15 million to $20 million for the full year.

Corporate G&A excluding $2 million in charges for Business Process Improvements and severance was $75 million in the third quarter of 2011, flat versus the prior year. For the fourth quarter, we expect corporate G&A to be in the $80 million to $85 million range. This increase is due to an increase in IT due to timing in the 53rd week in this fiscal year. Taking a look at cash flow, we ended the third quarter with free cash flow of $139 million and for the first 9 months of 2011, we had a use of cash of $69 million. We are making significant process -- progress on the nearly $120 million of second half working capital improvements that we projected, as we sell through the Direct import and forward buy inventories and trade payables return to normal levels.

Additionally, we continue to expect $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 nontrade payables and an increase in accruals related to bonus and long-term accruals -- long-term incentive accruals.

Turning to our liquidity, we ended the third quarter with $453 million of cash and cash equivalents and $766 million available from our Amended Credit Agreement for a total liquidity of over $1.2 billion. No amounts were drawn on the Amended Credit Agreement at quarter end as we repaid the $45 million of borrowings in Europe reported in the second quarter.

During the third quarter, we recorded a dividend on our convertible preferred stock of approximately $9 million, which was paid in cash on October 3.

Slide 14 provides a summary of our financial outlook for the fourth quarter and full year 2011. We expect total company sales to be up slightly in the fourth quarter versus the prior year. We expect to generate $30 million to $40 million in free cash flow for the full year, the relevant cash flow components include EBIT excluding charges is expected to be up in the fourth quarter compared to last year's total of $26 million and in the range of $100 million to $120 million -- excuse me, $100 to $110 million for the full year. A negative cash impact from restructuring charges of $50 million to $55 million, interest expense of approximately $70 million, cash taxes of $15 million to $20 million, capital expenditures in the $125 million to $130 million range and depreciation and amortization in the range of $210 million to $215 million. I'll now turn the call back over to Neil.

Neil R. Austrian

Thank you, Mike. I'm pleased with the traction we are getting in our North American businesses and the actions being taken in the International division. I'm encouraged that focusing on fewer key business initiatives is producing measurable results. Trust me when I tell you that our associates have heard me state on many occasions since taking over as CEO, "If you can't measure it, it didn't happen." Before opening up the call to Q&A, I'd like to note that Office Depot is marking its 25th anniversary this year, a significant milestone in this increasingly competitive world. As we embark on our next 25 years, our customer-centric philosophy still remains at the forefront of our business strategy. This is evident in the way we serve our shoppers through integrated sales channels and our diverse product assortment and in how we market our winning solutions.

In closing, we've made the necessary changes to our leadership team to put Office Depot in a winning position. We have a strong operating plan in place and a clear and exciting roadmap for the future. As we now enter the final stretch of 2011 and look forward to 2012, I'm truly excited about what the next 25 years will have to offer.

Kevin Peters

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

Question-and-Answer Session

Operator

[Operator Instructions] Our first question today is from Colin McGranahan.

Colin McGranahan - Sanford C. Bernstein & Co., LLC., Research Division

The company is Sanford Bernstein. First, looking at Slide 12, obviously, a lot of great progress has been made against some of the initiatives that you've outlined over the course of the past year. But obviously, there's been some reinvestment and then a negative deleveraging. So the net benefit is unfortunately, not very significant so far this year. So kind of 2 questions there. One is, as the economy looks like it's not helping and maybe even start to hurt, especially in Europe, how do you think the offset on sales to leverage will look going forward, and not just the next quarter but the next year, how are you thinking about that today in the economic? And then secondly, just in terms of that net benefit growing, sounds like some of the reinvestments have kind of an ongoing aspect to them although the consulting fees and one-time investments might help to the tune of maybe $20 million, is that the right way to think about it?

Neil R. Austrian

Yes, in looking at the plan for next year, it's pretty clear we don't see the cost [ph] of the economy improving at all. And that plans we've got, both domestic and international provide for that. I think what I'd say is that, had we not undertaken in the initiatives when we took them on, and had we not gotten the results that we've achieved to date, we wouldn't be sitting here with a positive attitude at this point in time. I think the way we look at it is we're going to continue to drive the initiatives, we think there is significantly more that we can get from each of the initiatives we've outlined and that our plan for next year really provides a significant increase in our EBIT number. But that's predicated on the economy not totally deteriorating either here or internationally.

Colin McGranahan - Sanford C. Bernstein & Co., LLC., Research Division

Okay, that's fair. And then one follow-up, I might have missed it, but I wasn't sure that I'd heard about the 53rd week before. Can you just give us a sense of what you think the operating profit impact of that will be so we can reconcile it?

Michael D. Newman

Colin, Mike Newman. It's modest, it actually has a different impact on our 3 businesses. In round numbers, it's somewhere around $5 million of EBIT for the whole company.

Operator

Our next question is from Chris Horvers.

Christopher Horvers - JP Morgan Chase & Co, Research Division

JPMorgan. First question, just on the EBIT guidance, what was the number that you were referring to last year?

Michael D. Newman

I believe it's $26 million adjusted for charges.

Christopher Horvers - JP Morgan Chase & Co, Research Division

Okay, so that includes the miscellaneous income?

Michael D. Newman

Yes.

Christopher Horvers - JP Morgan Chase & Co, Research Division

Okay, all right. Excellent. And then on the International side, it seems like France was up in 2Q, wasn't mentioned as being up here in 3Q. Retail side, again, up a little bit in 3Q and now down a little bit -- or up a little bit in 2Q and now down a little bit in 3Q. So as you think about the trend, did it stop getting worse at the end of the quarter or has the deterioration continued here through to October? And then from a modeling perspective, it seems like the local currency forecast for International would reflect, I guess an upturn in trends, so we're just trying to figure out what we're missing there?

Neil R. Austrian

As I look at the third quarter internationally, it's slightly better. What we found is that our Contract business in our key countries improved. Where we're having trouble right now is in our Direct channel, making the conversion from the Catalog business to the e-commerce platform, which we've been working on. We still have not resolved, to the extent we fought the pricing issue we had in one of the countries. We thought it would turnaround a lot quicker but it hasn't. And I guess the way I look at the situation today, we've got some countries that are doing extremely well, some countries that are doing just okay, and some other countries we really have to focus on and that's what I'm going to spend my time on the next couple of months, better understanding exactly what's going on country by country.

Christopher Horvers - JP Morgan Chase & Co, Research Division

So then, maybe just on the math -- did the flat in local currency, you were down 7, so I guess X that 53rd week, does that mean that you would expect the down 7, 8 X that 53rd week in the fourth quarter for International?

Neil R. Austrian

No. We think fourth quarter is going to be flat.

Christopher Horvers - JP Morgan Chase & Co, Research Division

Right. But including the 53rd week, it's flat, right? So that's -- you get 1/12 or something like that benefit?

Neil R. Austrian

You don't quite get a 1/12 in terms of that 53rd week because from a sales standpoint, it's pretty low in terms of sales. And in some cases, depending on the channel, Chris, you actually lose money in the 53rd week as opposed to making money.

Christopher Horvers - JP Morgan Chase & Co, Research Division

Okay. And then finally, on the North American Retail, the PC business, I know that you've eliminated the opening price point notebooks and that caused some pain. We're hearing in the channel that perhaps the PC business or notebook business improved in late August and then in September. Is that something that you saw in North American Retail?

Kevin Peters

Chris, it's Kevin. No, I wouldn't characterize an improvement in the notebook sales for us or the desktop sales. I wouldn't indicate that there has been a deterioration but it's been roughly flat. But again, most of that was driven intentionally by our decision to exit the entry point laptops.

Christopher Horvers - JP Morgan Chase & Co, Research Division

Okay. So really no change and the driver of that is an off steep of decision, not necessarily what's going on in the market?

Kevin Peters

Correct.

Operator

Our next question is from Matthew Fassler.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Goldman Sachs. I'd like to start off by just asking about the Mexico business. If you could talk to the year-on-year trend in Mexico earnings in the third quarter?

Neil R. Austrian

I'll ask Mike to do that, he's on the board.

Michael D. Newman

I would say it's stable. We haven't seen the growth that we've seen in prior years. It's softened a bit but it's still sustained from an earnings perspective. It's still sustaining year-over-year but we haven't seen the growth that we've seen in the previous few years.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

I guess if I look at last year's number, I believe the equity expense was a $12 million favorable number, and I guess this year it was less favorable, so is that all Mexico? And if not, what would drive the decline and the benefit to you?

Michael D. Newman

Yes, I think you're referring to the -- we record our Mexican JV income on the miscellaneous income line. That number versus last year for Mexico is relatively the same, but the miscellaneous income line is down approximately $5 million. Most of that is driven by foreign exchange losses on intercompany transactions that we have. This year, we have a weaker euro, last year we had a stronger euro at that time. And given the typical intercompany balances that we have, we recorded losses this year versus gains on those intercompany accounts. I know it's a little bit of a tricky math thing, but it's mostly FX that we have in that line, it's not the Mexican JV income.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Got it. That's very helpful. Second question I want to ask relates to BSD. What impact would you say that the U.S. community loss business had on your transactions? I think you said transactions were down, more or less in line with the total sales decline. How much of that would you attribute to the 14% of the business that you can retain from that Contract?

Kevin Peters

Matt, it's Kevin. I would say if you just looked at Contract sales year-over-year in the third quarter, the delta between our sales last year and this year were largely made up in the decline in that business. I think the other segments all were flat or up. So I think from a transaction standpoint and a sales dollars standpoint, most of the decline came from that business.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Got it. And then just a final question for Neil. Any thoughts on the succession management -- management succession plan that is for the International business?

Neil R. Austrian

Until I really get a much better handle in terms of what I think the issues are at this point in time, no. I'm planning to spend a good part of this last quarter really understanding exactly where we're going, both in Europe and in Asia and at some point in time, I'll make a decision. But right now, the way it's organized is they're reporting directly to me.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

But you'd expect at some point, to have another President or might you reconsider the structure at that point?

Neil R. Austrian

I didn't say I'd have another President. I'd say -- what I'm trying to do is really understand what we have to do to manage it effectively. When I get to that point, I'll make some kind of announcement.

Operator

Our next question comes from Kate McShane.

Ivan Holman

This is Ivan sitting in for Kate, company is Citigroup. We had a quick question with regards to Direct imports, you noted that it had hit about 14%, which was a 240 basis point increase versus last year. Can you remind us where you see the long term penetration of this and what the contribution margin is?

Kevin Peters

Ivan, this is Kevin. I think the improvement that we called out in the transcript was largely related to the North American Retail business. Although we've seen improvements both in North American Retail and BSD on the Direct import penetration. We haven't really set a target for Direct import penetration nor have we set a target for our own brands. We believe that there's still runway ahead of us in terms of further penetration, and I think on average to your second question, the Direct import private brand product margins are roughly 2x the national brands.

Ivan Holman

Okay, great. And just as a quick follow up, regarding your 5K formats, I believe you mentioned that you had retained 90% of the sales with roughly half of the SKUs. Going forward, will those stores carry the same type of SKUs that the pilot programs have? And will you be moving the 50% of SKUs that aren't in the stores online?

Kevin Peters

First of all, the reduction in SKUs, all of the SKUs that were reduced are carried online. The customers that are looking for those products can purchase them in the store. We have actually kiosks in each of the 5K stores so that we can actually transact that business while the customer is still inside the store. With regard to the product assortment going forward, I think it largely depends on the geographic area and the demographic that shop the stores. So we'll have a corset of the current 5K SKUs that will be represented in all 5K stores. But depending on the placement of that store, we may have some micro sorting opportunities for again, the demographics. So if we're close to schools and universities, we may have an assortment that looks different than if we were close to a medical or legal vertical.

Operator

Our next question is from Michael Lasser.

Michael Lasser - UBS Investment Bank, Research Division

UBS. Can you dimension the gross margin impact from lower technologies sales? And along those lines, in the fourth quarter, I imagine that technology is a bigger part of the mix so where do you get the confidence that on the retail side, comps is going to be about -- down about the same amount than it was in the third quarter?

Kevin Peters

One of the decisions -- Michael, this is Kevin. One of the decisions we've made is to exit the low-end laptop business. Principally because those laptops we had very little success in being able to attach to the laptops to drive profitable sales. Equally as important, those low-end laptops were typically sold to customers who we saw once and didn't see again. So our decision to exit that business was largely because the customers that were buying the products weren't long-term customers of Office Depot. And quite frankly, we didn't make a lot of money on the low-end laptops, in fact, we lost money. So as a result, we're actually slightly positive in terms of IGM dollars, in terms of exiting that business.

Michael Lasser - UBS Investment Bank, Research Division

And do you have a sense for what the gross margin gain was from that?

Kevin Peters

Call it mid-teens on a basis point basis.

Michael Lasser - UBS Investment Bank, Research Division

Okay. And then another element to the...

Michael D. Newman

Michael, this is Mike Newman, I'll just add to that by saying while the lower laptop sales had an impact on the overall Retail margin improvement of roughly 240 basis points, when you look inside of our categories, when you look at furniture, when you look at supplies, when you look at technology excluding laptops, every one of our categories was up over 100 basis points and a lot of it was driven by pricing and promotions. So a lot improvement was by initiatives, not a mix shift away from laptops.

Michael Lasser - UBS Investment Bank, Research Division

And that's really helpful. I guess the one risk would be that we've seen, in the past in the industry, that retailers have gotten a bunch of gross margin gains only to have that unwind later as the realization came that it wasn't sustainable. So maybe you can provide a little more detail on some of the different promotions and the different pricing strategies that led to these gains and [indiscernible]?

Kevin Peters

Yes, I think there's 2 things that I think I would call out that's driving the margin gains aside from mix. I think we've talked about, for the last couple of quarters, a specific intent that we have to be much more strategic in the way we think about pricing and we've talked about really taking a look at the assortment that sits not only inside of Retail but BSD as well and trying to understand the relationship between price and unit velocity and as we talked about in the second quarter, I think one of the things that we've uncovered is that when you look at, principally, in Retail, the number of SKUs that exhibit inelastic demand patterns, it's a significant piece of the overall assortment. So what we've been doing over the last several months is really spending a lot of time being much more strategic and thoughtful about how we price the assortment inside of Retail, not only with regard to the price volume relationship, but also with regard to where those stores are located, whether they're in suburban markets, whether they're in urban markets, a competitive set that exists in the market that the stores reside in, as well as the category management point of view in terms of categories we want to lead and gain share in versus categories that we just want to maintain. So a lot of the benefit that we're beginning to see in terms of our margin improvement has come from specific actions that we've taken with regard to pricing. Second piece of that is around promotions and it ties to pricing because we really think about promotion. If you're promoting items that add inelastic demand patterns, you're essentially giving margin dollars away. So we've been much more thoughtful about how and where we promote and specifically what SKUs. We've also taken a look at areas like our loyalty program to ensure that we're at parity in the areas where we're not a parity, if we're going to be differentiated from our competition, it's going to drive incremental revenue and margin for us. So we certainly have been less promotional in promotion and where we have been promotional only on those SKUs that give a relationship between price and volume.

Michael Lasser - UBS Investment Bank, Research Division

Okay. If I could add one more question. From the 5,000 -- from the experience with the 5,000 key stores, it sounds like you're seeing that a good chunk of your SKUs are not necessarily productive. So are you able to take those learnings and bring that into the bigger stores that you're not able to do anything with in the near term, and perhaps remove some of those SKUs and bring in more productive inventory? Is there an opportunity there?

Kevin Peters

I think it's certainly a tricky balance. If you think about our stores today, our stores roughly are 24,000 square feet. There's certainly opportunities to take inventory out. I think some of the working capital improvements that we saw in Q3 were as a result of doing some things with SKU rationalization and lowering the water level on SKUs that are at the tail end of the distribution. But at the same time, we've got to be respectful of the customer experience as well, we can't leave bare shelves in stores that are 24,000 square feet. So we've got to be balanced in terms of the inventory we take out but it's also we have to be respectful of the presentation with regard to how the customer perceives the shopping experience.

Operator

Our next question is from Emily Shanks.

Emily E. Shanks - Barclays Capital, Research Division

Barclays Capital. I just had a question around the balance sheet. I was hoping you could give us an update in terms of what your thought process is around the 2013 maturity and also remind us if you ultimately have the ability to refinance that with your ABL please?

Neil R. Austrian

We're in the process of looking at that right now, we have a lot of runway, time to think about it. So we've been in contact with our banks and we're assessing that. We have not come to any decision yet. As for the timing, obviously, eventually, we'll have to refinance it.

Emily E. Shanks - Barclays Capital, Research Division

Okay. And can you remind us if you have the ability to draw on the ABL to refi the whole thing, subject to the [indiscernible]?

Neil R. Austrian

We have the ability to use the ABL for a portion of it, yes. We could do all of it but from a capital planning standpoint, practically, we would likely refinance part of the outstanding bonds.

Operator

Our next question is from Dan Binder.

Daniel T. Binder - Jefferies & Company, Inc., Research Division

Jefferies. I had a couple of questions. One, I was just wondering if you could comment on the overall competitive environment, what you're seeing from both direct and indirect competitors here in the U.S.? Secondly, if you could give us a little bit of color on trend through the quarter. And then thirdly, any early thoughts about what charges and cost savings might look like for next year?

Neil R. Austrian

Kevin, do you want to talk about the competitive retail set?

Kevin Peters

I don't know that there's been really a lot of change inside of Retail Q2 to Q3 in terms of the competitive set. I think, clearly, competitors are really in 2 classes. It's the brick-and-mortar, as well as the Internet. I think the Internet is continuing to gain share, although it's still a really small piece of the pie. So I think challenge is for us, will be finding ways to integrate our Internet presence with our brick-and-mortar presence. But I wouldn't characterize the Retail environment as being more competitive than it has been. And I think even with regard to Back-to-School, I think it was about as competitive as it was last year.

Neil R. Austrian

I think on the benefit piece, we'll have a little more clarity on what we want to talk about when we put the annual operating plan together and we get a much firmer look at 2012, which we're in the process of doing right now. But I think what I would say is that, if you look at the chart that Mike showed in terms of the EBIT walk and what the initiatives contributed, we see a large part of those going forward.

Daniel T. Binder - Jefferies & Company, Inc., Research Division

And trends for the quarter?

Neil R. Austrian

I'm not sure I understand the question.

Unknown Executive

The sales trends through the quarter.

Daniel T. Binder - Jefferies & Company, Inc., Research Division

Sorry. The sales trends through the quarter. If there was any meaningful trends, better, worse, choppy across the different divisions?

Neil R. Austrian

I think it's basically the same. It's very competitive. And until there is any kind of a change in confidence among the small- and medium-sized business owners, where they decide that it's time to hire or rehire and increase the white collar of employment, I think you're going to see the same kind of trend going forward.

Daniel T. Binder - Jefferies & Company, Inc., Research Division

Okay. You made mention of the Internet competition in your earlier remark, a lot of investors are obviously, cognizant of the online threat and worry about Amazon but we've seen a lot of work from the wholesalers to enable other types of competitors, mainly the big-box retailers like Costco and Wal-Mart. And I'm just curious as you look at those as bigger competitors today than let's say, 3 years ago, are you inclined to narrow online pricing with them and really be different from what your pricing looks like in the stores?

Kevin Peters

I think the way that we're approaching -- certainly, with our Internet site, we're going to be competitive with other Internet sites, and we're also going to be competitive on the most visible items that sit inside of our Retail stores. Certainly, the wholesalers have been enablers of other e-commerce strategies. I don't know that, that would necessarily preclude us from taking similar advantage. And so I think as we look to our website and the growth of our website, I think there's certainly opportunities for us to expand the breadth of our assortment without necessarily having to obligate our infrastructure with those SKUs. So I think what may be good for others could also be good for Office Depot as well.

Operator

Our next question is from Joscelyn MacKay.

Joscelyn MacKay - Morningstar Inc., Research Division

This is Joscelyn MacKay at Morningstar. I just had a quick question based on your presentation. On Slide 14, you talked about the EBIT adjusted for charges being $100 million to $110 million for the full year. I guess I was just looking back to Slide 14 and adding up those charges and so that being about $54 million in total charges. So I was trying to get the buildup, if you look at your -- the financials presented this morning year-to-date, the non-GAAP EBIT is about $56 million, so if you add in that $26 million adjusted for charges for Q4, I'm only getting $82 million so that's a $20 million gap. So I'm wondering just if my math is off somehow.

Neil R. Austrian

I would probably -- to save everybody a 10-minute explanation, we'll have somebody in IR call you back later today to get you square on those.

Operator

Our next question is from Joe Feldman.

Joseph I. Feldman - Telsey Advisory Group LLC

Telsey Advisory Group. Quick question, and I apologize as I may have missed it in the prepared remarks, but when you guys are talking about Europe, I know you said U.K. and Germany were good. I may have missed what you said about France and Italy and other parts of Southern Europe, I was kind of curious what you're seeing there throughout the rest of the continent?

Neil R. Austrian

Basically, France is flat at this point in time, and we expect it to be about that way going forward. We haven't broken out sales for any of the other countries given the size. Basically, Italy and Spain are run through France. And as I look at that region, it's performing okay, is what I would say. The Retail businesses is kind of interesting. When you look at the stores, the Retail part has done well in the city stores, not as well outside the cities. Contract business has done as well as we could expect in this economy. It's the Direct business that hasn't performed.

Joseph I. Feldman - Telsey Advisory Group LLC

Got it. Okay, thanks for the color. And then one other question was if you could talk a little bit about the -- yesterday, you guys made the announcement of that new payment offering and I understand it's another service offering for small- and medium-sized business. I guess I was curious to get a little more color on what was driving that decision, how you felt there was the need and maybe what other services there could be and how you plan to market it. So just a little more color about the whole thing?

Kevin Peters

Joe, I think what you may not know is we actually had a payment service option that was available to customers prior to the announcement yesterday. We transitioned away from the provider that we were using and we're now using a different provider with a branded solution and it's essentially targeted to SMB, small retailers who want point-of-sale capabilities and they can do it through a branded tool like that tool we announced yesterday with Office Depot. So I think that, that piece, I think, with regard to services, if you look at the services space, it's $1 trillion spend for SMBs inside their G&L, or their general ledger. If you look at the indirect spend that they have, there's a large bucket of service opportunities, I think what we've got to do is we've got to identify the ones that have the closest adjacencies to office products and to pilot them. I mean, we're doing that now with areas like Tech Depot Services and Copy & Print Depot and Managed Print Services. So I think as we continue to identify those adjacent services, they tend to have attractive margins and they tend to help us create sticky customers.

Joseph I. Feldman - Telsey Advisory Group LLC

Got it. That's helpful. And if I could follow up with one more. Quick question about own brand, I know you guys have mentioned that you saw a bit of an increase in own-brand sales and I was just wondering, do you think that's just the continued challenging economy, that it's people traded down or do you think that you're doing just a better job presenting and with the offering and the merchandising of the own-brand product within the store?

Neil R. Austrian

I think the short answer is we have -- as Mike talked about earlier, we've made investments in our merchandising and our marketing organization. We have 2 very dynamic leaders that are responsible for those organizations. I think one of the things that we've realized is that we've essentially diluted the value of the Office Depot brand. We just haven't -- one, we haven't invested well in it. And two, we've positioned the brand as a second-tier brand to some of the national brands. And I think we've made a conscious decision now to begin the process of repositioning the Office Depot brands, as well as other adjacent brands to drive better choices for customers and help drive better margins for the business. So I think it was probably more of a conscious decision on our part to invest back in the brand and reposition the brand.

Operator

Our next question is from Alan Rifkin.

Alan M. Rifkin - Barclays Capital, Research Division

It's Alan Rifkin with Barclays. Bigger picture question for Neil. Neil, with the remodeled stores seemingly doing better than the rest of the portfolio, as well as the 5K stores doing as well as they are, what is your willingness as you start to head into the new year to take a more aggressive posture with rationalizing your store base, even for stores that may be cash flow positive but yet are not yielding their proper IRR?

Neil R. Austrian

I think you have to look at it on a different basis. I think you have to look at a couple of things. One, we've basically made a determination ourselves that we're going to be cash flow positive, period, until we have a better look at the economy. Secondly, we have very few stores at this point in time that are losing money and performing poorly. And we are going to make the investment in the 5K stores. We are going to open additional 5K stores. I think the key is where we open them and how we open them. We have a plan, which Mike has talked about in the past, about our North American Retail occupancy cost, which is about a $500 million cost per year, where we think over the next 5 to 6 years, well over half of our stores come up for lease renewal. The best thing we can do from a cash perspective and a business perspective is make the decision at the time of renewal. What we're going to do in terms of either downsizing the store, relocating the store, remodeling the store or just killing it and putting a 5K or some other variant in. So I think we're very conscious of this. I think what I would say is that with the success we've had with the 5K stores, to date. Everybody understands how important it is that we drive that initiative, and I think you'll see that in the next couple of years.

Alan M. Rifkin - Barclays Capital, Research Division

Okay. One follow up if I may, Neil. Just generally speaking, as you look at your portfolio of vendors with respect to payment terms, if you were to compare today versus either 6 or 12 months ago, are you seeing a greater number of eased terms with you or tightened terms or maintain the same terms as where we were [indiscernible]?

Neil R. Austrian

I'll ask Mike to talk about that but from what I've learned, we haven't had any issues whatsoever with our vendors in the past year plus. But let me turn it over to Mike.

Michael D. Newman

That's right. We've seen same terms domestically. What we've done internationally, which is a little bit different on our direct import is, as we've got higher penetration, we've work with vendors to better match the terms with the product cycle in the pipeline. So we've actually made some changes that will impact our fourth quarter and 2012 cash flow to better align payment terms with how long it takes to get a product here from DI. Other than that, I would say, on balance in a company this size, our terms are relatively the same.

Neil R. Austrian

I mean, if the question is, are any of our vendors are concerned about our liquidity, the answer is no.

Operator

And our final question today is from Jeremy Brunelli.

Jeremy Brunelli

Consumer Edge Research. On the North American businesses, you commented on your trends for Back-to-School versus your channel, I guess, versus the tracked channels, can you comment on the total North American Retail business versus tracked channels and also total North American delivery or BSD versus tracked channels in terms of share trends, et cetera. And any product level detail also would be helpful?

Michael D. Newman

It's a good question. I wouldn't say that we haven't spent a lot of time looking at both the BSD or North American Retail business at the track level. What we tried to do is look at it at the product category level and specifically, as it relates to Back-to-School and the SKUs that track with the back-to-school season as we said, we're up about 120 or so basis point, both in terms of sales and margin. If you look at the other categories that sit inside of our North American Retail business, we comped positively, not only in Supplies but we comped positively in Copy and Print Depot or Tech Depot Services. Where we had headwind was uniquely related to the laptop sales, which we've discussed and peripherals which tend to go hand-in-hand with the laptop. So I think, aside from those categories, our general sense is that we're -- the positive comp sales would suggest that we're trending at parity with the broader set.

Jeremy Brunelli

Okay. And then in BSD?

Kevin Peters

We don't probably look at product sales on a more macro basis in BSDs, because so much of our business is on Contract and tied to core products. So don't really spend a lot of time looking at product sales in that channel.

Jeremy Brunelli

Okay, and then just one final question on the European business. The weakness that you've seen in the Direct business, I know you commented on it partially being related to the transition to e-commerce channel. But is there any implications from increased competitive activity there?

Neil R. Austrian

No. I don't think so. I think we've made some changes in how we presented our catalog. With the thing that Charlie talked about in terms of project accelerate, and I think in hindsight, as you look at it, we could have executed a lot better. But that's the only thing at this point in time.

Operator

And that concludes the question-and-answer session. I would like to turn the call back over to your presenters for any closing comments.

Brian Turcotte

This is Brian, I'll be taking calls for the balance of the day, thank you for tuning in and we'll speak to you soon. Thanks.

Operator

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

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