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Staples (NASDAQ:SPLS)

Q3 2011 Earnings Call

November 15, 2011 9:00 am ET

Executives

Joseph G. Doody - President of North American Delivery

Ronald L. Sargent - Chairman, Chief Executive Officer and Chairman of Executive Committee

Michael A. Miles - President, Chief Operating Officer and President of Staples International

Demos Parneros - President of US Stores

Chris Powers -

John J. Mahoney - Vice-Chairman and Chief Financial Officer

Analysts

Ivan Holman - Citigroup Inc, Research Division

Chris Lang

Anthony C. Chukumba - BB&T Capital Markets, Research Division

Kelly Chen - Telsey Advisory Group LLC

Joscelyn MacKay - Morningstar Inc., Research Division

Bonanza Chalaban - KeyBanc Capital Markets Inc., Research Division

Aaron Goldstein - JP Morgan Chase & Co, Research Division

Gary Balter - Crédit Suisse AG, Research Division

David Gober - Morgan Stanley, Research Division

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

R. Scott Tilghman - Caris & Company, Inc., Research Division

Oliver Wintermantel - ISI Group Inc., Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Third Quarter 2011 Staples Earnings Conference Call. My name is Towanda, and I will be your coordinator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to Mr. Chris Powers, Director of Investor Relations. Please proceed, sir.

Chris Powers

Good morning, everyone, and thanks for joining us for our third quarter 2011 earnings announcement. During today's call, we will discuss some non-GAAP metrics to provide investors with useful information about our financial performance. Please see the Financial Measures/Other Data section of the Investor Information portion of www.staples.com for an explanation and reconciliation of such measures and other calculations of financial measures that we use to analyze our business.

I'd also like to remind you that certain information discussed on this call constitutes forward-looking statements for the purposes of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by such forward-looking statements as a result of various important factors, including those discussed or referenced under the heading Risk Factors and elsewhere in Staples' latest 10-Q filed this morning.

Here to discuss Staples' Q3 performance and business outlook are Ron Sargent, Chairman and Chief Executive Officer; Mike Miles, President and Chief Operating Officer; and John Mahoney, Vice Chairman and Chief Financial Officer. Also joining us are Demos Parneros, President of U.S. Stores; and Joe Doody, President of North American Delivery. Ron?

Ronald L. Sargent

Thanks, Chris, and good morning, everybody. Thanks for joining us today to hear about our third quarter results.

First, the headlines. Total company sales increased to $6.6 billion, operating margin expanded to 8.1% and adjusted earnings per share were up 15% to $0.47 for the quarter. We continue to make progress managing the business in a pretty tough environment and our cash flows remain very strong. Year-to-date, we've generated $852 million of free cash flow, and we have returned $700 million to our shareholders through dividends and share repurchase.

During the third quarter, North American Delivery grew the top line 2%, with growth in both Staples.com and Contract. Sales in North American Retail were flat. And in International, the top line decreased 2% in U.S. dollars and 7% in local currency, as business trends in Europe and Australia were softer than we expected. Operating margins were up in both North American Delivery and North American Retail. And in International, the progress we've made to streamline our cost structure was more than offset by lower-than-expected sales. In total, we had a solid quarter with strong performance in North America and in our growth initiatives and soft performance in International, driven by weak sales.

Now let's take a look at each of our business units in a bit more detail, and I'm going to start with North American Delivery this morning. Sales for the third quarter were $2.6 billion, up 2%, marking the seventh consecutive quarter of growth, while Staples.com and Contract had low single-digit top line growth and Quill was flat for the quarter. We're gaining momentum in facilities and breakroom, which is now an $800 million category within North American Delivery. During the third quarter, we achieved strong double-digit growth in Contract, Staples.com and Quill in this category. The investments we've made in marketing, pricing, sales force, as well as an expanded assortment, helped drive the top line in facilities.

We saw strength in computers, technology peripherals and Copy & Print, while paper was down slightly. We also drove solid growth in other adjacent categories during the third quarter. Promotional products grew double-digits and achieved record sales for the quarter, and Print Solutions achieved high single-digit organic top line growth.

In Contract, customer acquisition and retention was strong while sales to existing customers were down 1%, and that reflects an improvement to the trend. Sales in the mid-market segment outperformed sales to Fortune 1000 customers, and we remain very disciplined in managing account profitability. In Staples.com, enhancements we've made to our website, including an expanded print offering, electronic software distribution and proactive chat are all gaining traction.

Now turning to profitability. The NAD team did a great job in Q3 and increased operating margin 63 basis points to 9.5% with improvement across each of our businesses. Improved profitability in Canada, as well as our facilities and breakroom and promotional products businesses in the United States, was partially offset by increased spend on information systems and higher fuel expense during the quarter.

We're in the final stages in the integration of Corporate Express in North America this year. We've been focused on completing our warehouse integration. We now have 35 fulfillment centers with systems capable of serving both Staples and Corporate Express customers. We've also developed our new ordering platform for Contract customers called staplesadvantage.com. During the third quarter, we moved all of our legacy Staples customers over to the new platform. And over the coming quarters, we will be transitioning the legacy Corporate Express customers as well. This new site is much more personalized, offers customers improved navigation, robust search and browse, and easier access to previously ordered items. We feel that this new website will further differentiate our Contract offering in the marketplace.

Moving on to North American Retail. Sales in retail for the third quarter were $2.7 billion. It was flat in both U.S. dollars and local currency compared to Q3 of 2010. Same-store sales were down 1% as we achieved flat comps in the United States and trends improved in Canada. Customer account comps decreased 1% compared to Q3 of last year and average order size was about flat. Strength in core office supplies, laptop computers and new technology like tablets and eReaders was offset by weakness in desktop computers, software and computer media. Our expanded assortment of facilities and breakroom supplies in retail continue to perform very well with strong double-digit growth during the third quarter.

During the back-to-school season, we achieved low single-digit comps and improved profitability versus last year. An increase in average ticket was partially offset by a small decline in traffic for the season. We grew the top line in core office supplies, and our technology promotions and new college dorm assortment resonated well with our customers during back-to-school.

Taking a look at our adjacent businesses, we had low single digit comps in Copy & Print during the third quarter. This reflects the benefits from investing in our sales force, as well as the recently expanded range of products and services offered in stores and on our website. And our EasyTech business also continues to comp above the house as customers took advantage of our $9.99 PC Tune Up promotion.

North American Retail operating margin was 10.7% for the quarter, and that was up 12 basis points year-over-year. This reflects improved product margins as a result of more efficient marketing, partially offset by higher labor expense and investments in growth initiatives.

We have big plans to drive traffic this holiday season. This year, we'll have a wide assortment of the hottest new products and brands, including Kindle Fire, Nook Tablet, Keurig coffee makers and a variety of gift products from Brookstone. We're also now selling Apple products in our stores in Canada, including the iPad 2. We're working to further increase awareness of our Copy & Print services by offering discounts on holiday cards, invitations and calendars. And we're very excited to be partnering with Martha Stewart in launching a broad line of innovative and fashionable products early next year.

During the third quarter, we opened 4 stores and we closed 3 stores, ending Q3 with 1,908 stores in North America. That's 1,575 in the United States and 333 in Canada. We remain on track for a net addition of 20 stores in North America for the full year. We continue to make progress with the 150 store leases up for renewal this year as well. We've had a lot of success renegotiating rents, in many cases below our current rental rates.

We also remain focused on increasing store productivity by continuing to invest in new growth ideas. Year-to-date, we've added over 375 mobile phone departments, bringing our total for the chain to about 450 at the end of the quarter, and we're on track to add about 50 more of these by the end of the year. This year, we've also remodeled more than 60 copy centers. We've added 80 Copy & Print account managers and made great headway improving the quality of this $600 million business for the company.

And with that, I'll turn it over to Mike to talk about our International business. Mike?

Michael A. Miles

Thanks, Ron. Good morning, everyone. Staples International recorded third quarter sales of $1.3 billion, a 7% decline in local currency from 2010 and a 2% decline in U.S. dollars. The European debt crisis hit the business hard in Q3 as the trend toward improving sales in Europe softened. Australia also had a soft quarter with top line weakness across all major lines of business.

International operating margin for the third quarter declined 136 basis points to 3%. While we made progress on our profit improvement programs last quarter, it was not enough to offset the deleverage of fixed costs on lower sales in both Australia and European Retail, as well as onetime expenses associated with the launch of SAP in Australia. Australia represented the majority of the operating margin deleverage in International during the third quarter.

In Europe, our business turned negative in August, coinciding with the escalation of sovereign debt concerns. Europe office products declined 5% in local currency for the quarter after showing 2% growth in Q2. Delivery continues to outperform retail, with particular strength in Contract, which grew sales 2% in local currency versus last year. Our European Retail comps were down 12% for the quarter, with weakness across all markets other than Norway, where we had low single-digit positive comps. Tech hardware sales continued to drag down the averages, with a combination of weak demand and intense competition making that category very difficult.

We continue to carefully manage our contract pricing disciplines, pass through cost increases and increase our mix of Staples brand product in Europe. The team there has done a nice job managing expenses this year. However, that was more than offset by deleverage of store rents and fixed supply-chain expense.

We're encouraged by the early success of the mid-market sales force in Europe. We launched our first European team in Birmingham, England this last year, back in 2010, and have expanded to London and Munich this year. Mid-market Contract customer has been the key to Staples' growth and profitability in the U.S. Contract space over the past decade. And while this is still a very small part of our European Contract business, our sales associates in Europe have achieved similar results to their U.S. counterparts and are sharing best practices along the way. We look forward to expanding this effort in Europe in 2012 and introducing it in Australia.

Turning to Australia. Consumer and business confidence there remain low. Sales were down across-the-board, particularly in discretionary categories like furniture and promotional product, and customer acquisition was soft. Although our SAP implementation went smoothly for most of our customers, we lost 2 days of sales and sales force productivity during the cutover. We also incurred incremental G&A and labor expense to minimize customer disruption. Going forward, we're excited about the advantages that SAP will provide as we improve efficiencies and streamline our existing processes.

We have made a leadership change in Australia. Jay Mutschler, who has been SVP for our North American Contract business, become President of Staples Australia. Jay has 30 years of experience in office products and was President of U.S. Operations for Corporate Express prior to the acquisition.

Our high-growth markets, including Brazil, India and China, achieved good overall growth and reduced operating losses in line with our plans. Jo Verbeek, a 14-year Staples veteran with significant supply chain experience, became President of Staples China in Q3. I'm excited to have his operational focus on this important growth vehicle.

Now I'd like to turn it over to John to review our financials.

John J. Mahoney

Thanks, Mike. For the third quarter, total company sales increased about 0.5% versus the year -- versus last year to $6.6 billion. Foreign exchange impact from the weaker U.S. dollar helped the top line by about 150 basis points during Q3.

Our third quarter GAAP earnings per share on a fully diluted basis increased 18% to $0.47 versus the third quarter of 2010. Excluding $9 million of pretax integration and restructuring expense during the third quarter of last year, adjusted earnings per diluted share grew 15% year-over-year.

Gross margin increased by 31 basis points to 27.9% during the third quarter. This reflects improved product margins, partially offset by increased fuel expense. SG&A increased 19 basis points versus last year's third quarter, primarily due to investments in labor to support initiatives, partially offset by lower depreciation expense. Excluding integration and restructuring expense in Q3 of last year, total company operating margin increased 11 basis points during the third quarter to 8.1%.

Our effective tax rate for the quarter was 33.5%. This is about 400 basis points lower than our tax rate during last year's third quarter, mainly due to the renewal of certain tax provisions late in 2010. Year-to-date capital expenditures came in at $244 million compared to the $246 million that we spent on capital during the same period last year. With year-to-date operating cash flow of $1.1 billion, we've generated $852 million in free cash flow through the third quarter this year. We remain on track to spend about $400 million on CapEx and generate more than $1 billion of free cash flow this year.

During the third quarter, we repurchased 10 million shares for $144 million. At the end of Q3, we had $700 million shares outstanding. The weighted average shares outstanding used to calculate diluted earnings per share for the quarter was $698 million. At the end of Q3, Staples had approximately $2.3 billion in liquidity, including cash and cash equivalents of about $1.1 billion and available lines of credit of about $1.3 billion.

Looking ahead to the fourth quarter. We expect to achieve flat to low single-digit total company sales growth compared to Q4 of last year. We expect to achieve diluted earnings per share in the range of $0.39 to $0.43 for the fourth quarter and adjusted diluted earnings per share of $1.35 to $1.39 for the year. Over the past few quarters, we've commented that we'd be at the higher end of our earnings guidance as sales trends improved. Through Q3, we haven't seen any real improvement in the top line, and as a result, have adjusted our view for the remainder of the year accordingly. Our full year earnings guidance excludes the $0.03 per share tax refund that we realized in Q2. Excluding this refund, we anticipate a 34% effective tax rate for the year. Our year-to-date share repurchase activity has come in ahead of plan. We now expect to spend about $600 million on share repurchases for the full year, up from our previous guidance of $300 million to $500 million.

Thank you for your time this morning. I'll now turn it back over to Towanda for Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Gary Balter with Crédit Suisse.

Gary Balter - Crédit Suisse AG, Research Division

Just a couple of questions or one question and a follow-up. I'm not sure of the rules. You mentioned that -- and John just mentioned about how you adjusted guidance down because of the fact that you're not seeing the top line growth. Can you talk about what you're doing to drive that top line? Because obviously, you had very solid margins in North American Delivery, North American Retail. So is there some thought process, maybe we should be giving back some of that margin to drive some top line?

Ronald L. Sargent

When I look at our business going forward, I think we're making all the investments we can make. But if you look at our Q4 guidance, I think it reflects our best thinking at this point. We want to be conservative on the top line given the environment that we're operating on -- we're operating in. We certainly don't expect the European economy to get a lot better in the next 90 days. And if sales do get better and some of the investments we have made, and I've kind of listed them in both our retail business and our delivery business, you can expect us to be at the higher end of guidance. But I think we're spending appropriately, given the results we're getting. And we'll let business spending and consumer spending determine it 3 months from now. John?

John J. Mahoney

I'd just maybe add that, I think, Gary, as you take a look at our growth initiatives, the 3 big ones, the tech, the Copy & Print and the facilities and breakroom initiatives -- facilities and breakroom, I think, we mentioned has now gotten to about $800 million and it's growing mid-teens. We're trying to invest in that as fast as we can, adding sales force, adding products, vendor relationships. And I think the dollars in sales growth are going to accelerate and hopefully soon will begin to offset some of the declines in some of the categories like computer media and software and some of those categories that customers are changing the way they access that product. Tech and Copy & Print similarly are beginning to get to the point where the critical mass is going to hopefully deliver strong sales growth, enough to carry the whole company as it gets bigger in total dollars. The challenge is, how much can we absorb of some of the new things that we're doing? And we're trying to push the teams as hard as we can to take as much investment and absorb as much of both capital and P&L that will help drive those businesses and hopefully continue to transform Staples as a business.

Gary Balter - Crédit Suisse AG, Research Division

And just a follow-up, and I'll let you go. But you mentioned 150 stores up for remodel or up to kind of -- the leases are up. Demos, could you talk about the progress? Because last time when we were there, you talked about how you're getting the same sales productivity, the same total sales out of the smaller store that you were when -- from the larger store. Is that still continuing as you transform more stores?

Demos Parneros

Yes, the trend is continuing with the lease renewal program. So we're pleased with the overall sort of hit rate that we are seeing at the moment. So it's about 150 leases per year for the next 3 years, maybe a little bit more than that, close to 500 actually over a 3-year period. And we're seeing no reasonable savings on rent, both current and option rent. In terms of smaller stores, as you know, it's difficult to downsize stores and landlords often opt to just give us a rent savings, which kind of works for them and works for us, but we're unable to actually shrink the store. In cases we're actually relocating stores, I think we've been pretty careful about how to allocate space and we've reduced space in categories like furniture and we've increased space in areas like services and some of the other emerging businesses, like tablets and mobile phones. And we've been able to be a little bit more efficient with space. So the goal for us is smaller stores, equal to or better productivity. And obviously a challenge, but we're happy with the way that's going so far.

Operator

Your next question comes from the line of Oliver Wintermantel with ISI.

Oliver Wintermantel - ISI Group Inc., Research Division

I have a question for Mike. Mike, many European countries look like they can't avoid a recession next year. And with your productivity and the comps down already, what are the exact levers in the International business that you could -- to pull to keep that business from deteriorating further?

Michael A. Miles

Well, I think they're the same levers generally that we've been talking about, but probably even more of the medicine than we had been planning to take in any case. I think G&A remains our principal lever for improving profitability in Europe. And I think both in the office products business and PSD, we've got significant plans already in place to take G&A down. And we've got the teams right now going back and rescrubbing those to account for the current economic reality. Obviously, the key for us is to balance the reduction in headcount that we need to do with the severance expenses that are part of the European environment. And managing that through the P&L is something that's a challenge for us. But I think we still see plenty of opportunity to reduce expense in Europe, just as we have. Obviously, it's harder to show leverage with the current economic results.

Oliver Wintermantel - ISI Group Inc., Research Division

Okay. I just had a question on SG&A as well. It looked like the growth in the first quarter and second quarter accelerated year-over-year with your investments in the growth initiatives, but it slowed in the third quarter. So can you just -- how should we think about SG&A dollars in next year? Are there bigger investments on the horizon? Or should SG&A dollars grow more in line with the sales next year?

Ronald L. Sargent

John?

John J. Mahoney

Well, I think as we were saying earlier, we're trying to invest as heavily on those as we possibly can, given the organization's ability to absorb the incremental investment, both in terms of the change in headcount. I think the third quarter largely, the G&A, I want to call it, deceleration was based on the size of the quarter. I think we spent about the same number of dollars, but the percentage was a little bit lower based on the fact that the quarter has higher revenues than the first and second quarter.

Operator

Your next question comes from the line of Chris Horvers with JPMorgan.

Aaron Goldstein - JP Morgan Chase & Co, Research Division

It's Aaron Goldstein for Chris. First, can you maybe help quantify the lost sales and margin impact, maybe bucket from the SAP?

Ronald L. Sargent

Are you talking about Australia?

Aaron Goldstein - JP Morgan Chase & Co, Research Division

Yes.

Michael A. Miles

I think it's principally in Australia, Aaron. And it's a little hard to know for sure at this stage. I wouldn't put too much of the burden on SAP, but the majority of the lost sales in Australia during the quarter were lower sales from existing customers as opposed to lost customers. And I think that given that, given the fact that we lost a couple of days of sales while we were making the cutover, it probably was an important part of the sales decline in Australia. I think we're able to get the business now refocused on customers, refocused on growing the top line. And I think we'll see better results from Australia in the months and certainly in 2012.

Aaron Goldstein - JP Morgan Chase & Co, Research Division

All right. And then maybe switching to North American Delivery. Are you seeing any changes year-over-year in the kind of the promotional or competitive environment in the context of delivery business? And are you still taking market share, do you think?

Ronald L. Sargent

We'll ask Joe Doody to answer that one.

Joseph G. Doody

Yes, Aaron, it's always been competitive and it continues to be competitive. So we are taking market share. As Ron said, we've got 7 consecutive quarters of growth. Our 2-year sales growth this quarter was plus 10, plus 11 versus our 2 major direct competitors. And we're doing it very profitably with more than a 600-basis-points difference in profitability. So I think we're managing the business carefully to get growth and also growth in profitability. And competitively, you're going to find it's -- there's some one-offs that always go on out there. But generally speaking, it's competitive, always has been and we expect it to continue.

Operator

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

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

A couple of questions. First of all, within NAD, good to hear that the sales to existing customers are improving. That being said -- or the rate exchange is improving to the extent that the overall sales growth decelerated a little bit. Can you talk about what's transpiring with new customer wins and whether there's -- might be another number that explains of the divergence in those trends?

Ronald L. Sargent

Joe?

Joseph G. Doody

Yes, I think the sales to existing customers is -- tends to be a number we use in the Contract business, so it's more heavily geared towards Contract than it is to the others. I think, generally speaking, we're still negative in terms of sales to existing customers. And slightly negative, but it's still negative in our Contract business and that's continuing to hold us back. We're very happy with our acquisition activity. We had a good quarter for new customer acquisitions, but it's still the weightiness of some of our larger customers, and those are the ones that are most cautious right now. The bigger Fortune 1000 customers are concerning us, as well as we had a weak quarter in terms of the federal government, for example. That was down over 20%. So there's some areas of weakness there, Matt. But as Ron said, overall, the trend is a little bit better in terms of existing customer sales.

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

Got it. And then my second question relates to a strategic look at your International assets. I'm looking at my spreadsheet on European Retail and the numbers have been under pressure going back now a number of years, continuously. There really was no recovery in European comps. Obviously, this is a very unusual moment in the European economy, so it's probably not the kind of moment to make big strategic decisions. But given this very long track record of eroding sales, are you reconsidering the strategic value of the business within your portfolio?

Ronald L. Sargent

Mike?

Michael A. Miles

Yes, Matt, I think we're frustrated obviously with our European Retail results, but we continue to believe that it's a good long-term business for us. We're profitable in every country in Europe except for Belgium, and that's 6 stores. Customer reach that we've done continues to show and confirm that the office superstore has a real appeal in terms of convenience, the full line of products that it offers and services. As is the case in the U.S., multichannel is an important part of the business, and I think a distinctive advantage for Staples. We also see a lot of room for improvement, as is evidenced by what you just shared about the last several years, and some good evidence of traction for things like copy center, tech services and attachment selling. So I think although the comp trends have been very difficult, we continue to see a role for the retail business in Europe, although I think certainly, our growth in Europe in the years to come will be more in the mid-market and the dot-com space than it would be with new retail stores.

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

And then, Mike, just a very quick kind of follow-up to that. It sounds like European profits, given the sales, were not that bad. Any sense of the profit trend or margin trend you could give us quantitatively in the European business?

Michael A. Miles

Well, I think as I said, the team did a terrific job managing the P&L, given the sort of 700-basis-point turnaround in the top line. Gross margins were about flat to prior year. We've taken out like 7% of our G&A headcount. In the middle of the P&L, the other selling expenses, we were able to manage those consistent to the sales declines. Where we deleveraged was completely in the supply chain and the rents. That accounted for all of -- effectively, all of the deleverage that we saw in Europe. And that was generally true in the International P&L overall.

Ronald L. Sargent

Matt, when you look at total International, I mean, Australia was a large portion of the deleverage this quarter. And just kind of a factoid, International represents about 20% of our sales in the quarter. It represents about 7% of our profits. And that includes, obviously, losses in China, kind of break-even business in some of the fast-growing markets. So Europe is not as bad as International by any stretch of the imagination, particularly on the delivery side. Retail has been really tough this year. And frankly, we expect that to continue, although -- then we have a little easier comparison next quarter in retail.

Operator

Your next question comes from the line of Kate McShane with Citi Investment Research.

Ivan Holman - Citigroup Inc, Research Division

This is Ivan sitting in for Kate. Can you comment on inflationary pressures in the quarter and how this compares to prior quarters? Specifically, if you can, which categories are you seeing the most pressure? And which categories have you been able to pass along price increases in?

Ronald L. Sargent

John, do you want to take that one?

John J. Mahoney

Yes, I think it sort of varies by category. As you know, a good chunk of our technology business is pretty much immune to inflation and almost has deflation in it, as advances in technology lead to more competitive pricing. Paper has been a category that traditionally is an important part of our business. And over the last couple of years, we've seen fairly substantial inflation in paper. That's abated a little bit this year, and we've generally been able to pass on the increases that we've seen. And throughout the rest of our core office supply categories, there's been relatively limited amounts of inflation and what we have, we've generally been able to pass on. As you see with our gross margin rates, we've done a pretty good job overall in maintaining a combination of mix and pricing to deliver improving margins.

Ivan Holman - Citigroup Inc, Research Division

Okay, great. So you haven't seen, just to kind of summarize, any real acceleration from the second quarter, just kind of the same type of trends.

John J. Mahoney

That's correct.

Operator

Your next question comes from the line of Brad Thomas with KeyBanc Capital Markets.

Bonanza Chalaban - KeyBanc Capital Markets Inc., Research Division

This is Bonanza Chalaban in place of Brad Thomas. You mentioned the Australia weakness. What do you think is driving that? And what are you doing to improve customer acquisition in sales there?

Ronald L. Sargent

Mike?

Michael A. Miles

Yes, Australia, we had a tough quarter. And it's actually been sort of a difficult year for us in Australia. I think from a P&L standpoint, we incurred significant additional cost in supply chain, salary and G&A, largely associated with the SAP cutover. And then we had double-digit negative sales declines, which was significantly worse than the second quarter, and as a result saw, as Ron said, a tremendous amount of deleverage in the business. I think we're very excited to have Jay Mutschler taking over that business. He was, as I mentioned, President of Corporate Express for the U.S. and has a tremendous amount of experience in the industry. He also led our facilities initiative here, which has been very successful. And I think as we look forward, there is a lot of opportunity in the top line there. There's obviously work to do with our existing customers turning around the sales. But we think that the mid-market offers us the same kind of potential in Australia that we're beginning to see evidence of in Europe and plan a significant effort in the mid-market in Australia in 2012.

Operator

Your next question comes from the line of David Gober with Morgan Stanley.

David Gober - Morgan Stanley, Research Division

Just a quick one for John, and then I have a follow-up for Ron. On the gross margins, I was wondering if you could just dig in a little bit more in terms of what the product mix was that provided the benefit and how much of that was a mix shift towards services on the retail side.

John J. Mahoney

Well, I think that's absolutely the key, is the mix towards services is driving a big chunk of the improvement. As we've seen over the last several quarters, Copy & Print and tech services grow substantially faster than the rest of the store, and services is approaching 10% of our total sales at this point. So it's probably the biggest driver. But we also continue to see good success with Staples-branded product, which has higher margins. And I think we've been -- as we've evolved our tech initiative, we've been less item-priced promotional with low-end PCs, and that's helped our margin as well.

David Gober - Morgan Stanley, Research Division

Okay, great. And Ron, just from a bigger picture perspective, I know you guys talked a little bit about what the impact on European sales was in terms of the debt crisis. But I was just curious what you're seeing from businesses more broadly in the U.S., and whether or not you think that some of the negative headlines and some of the fears that went on around the debt ceiling and European debt crisis and kind of the market volatility that we've seen over the last 3 months. I mean, is there anything you can pick up from a week-to-week basis that suggests that's having an impact on the business? Or is it really other factors that have been driving things?

Ronald L. Sargent

Well, I certainly think that's all a factor. And Joe Doody, he firmly believes that if the headlines are bad or the volatility is high, it affect his sales immediately. I'm not sure that's an economic view, but that's a Joe Doody view. When you look at what's going on, I mean, we don't see a lot of change in the economy versus our outlook last quarter. I think we remain in a slow-growth economy for business in North America. And that's really driven by high unemployment and fear of the future. But I read something the other day that consumer spending is in fact kind of about where it was when the recession began. So the consumer has held up a lot better than small-business spending, which obviously is 80% -- businesses are about 80% of our sales. As you know, and I think in Europe, I think the economy has gotten worse over the last few months with the sovereign debt issues there, and you couple that with government austerity programs. And you look at our portfolio of businesses, the growth economies for us would include places like China and India and Brazil. And surprisingly, Norway has been very good, but that's been bolstered by the oil economy in the North Sea. So there's certainly a lot of crummy data out there, whether it's wages or income or net worth. The unemployment rate doesn't seem to be moving any, but the consumer has held up surprisingly well compared to businesses.

Operator

Your next question comes from the line of Anthony Chukumba with BB&T Capital Markets.

Anthony C. Chukumba - BB&T Capital Markets, Research Division

Yes, I just had a quick question. You mentioned that you now have Apple products, including the iPad, in your Canadian stores. And I thought that was quite interesting. Do you think that, that could be sort of a positive harbinger for eventually getting Apple products in your North American stores?

Ronald L. Sargent

Well, we certainly hope so. I mean, our Canadian business is doing a great job with iPads outside the United States. We also sell the product in places as diverse as India and China and the Netherlands. And so we're certainly hopeful that we're going to be able to get the product into the United States as well in the future.

Anthony C. Chukumba - BB&T Capital Markets, Research Division

Okay. And in terms of the Canadian stores, just to clarify, do you also have just your Apple PCs, like your MacBooks and so forth?

Ronald L. Sargent

Yes. Not in every store, but yes, we have kind of a full range of Apple products. And certainly, in our high-volume tech-heavy stores, we sell the MacBook and the full line.

Operator

Your next question comes from the line of Michael Lasser with UBS.

Chris Lang

This is Chris Lang filling in for Michael. So talking about Europe. What can you do to preserve the profitability of the International segment in the event that Europe goes into a recession? And I know it's early and I know that you guys mentioned that you see the economic environments are still really weak going forward, but I guess, could you speak a little more to, I guess, what you expect to see as a change in the environment, if any?

Ronald L. Sargent

Mike, you want to weigh in?

Michael A. Miles

I'll certainly talk -- answer the first question in terms of the European P&L and what we're doing about it. I think as we look at the economy there and obviously, as I said, the fact that it softened up significantly by about 700 basis points over the second quarter, we're taking an even harder look at the G&A reductions. We've obviously pulled back earlier this year on some of the growth initiatives in Europe, just recognizing the P&L, as well as other initiatives that you might like to do if you had a little bit more wind at your back in terms of sales. I think G&A continues to be the principal lever we have in Europe to improve profitability or to maintain profitability. And as I said, the challenge for us, in terms of the reported numbers, is balancing the headcount reductions that we need to do for a lower level of business with the severance expenses that are associated with taking those actions in Europe. I think we're excited to have some things in Europe that are working, like the mid-market initiative. And we just have to balance the investment in those with the overall sales level we've got going forward. The most important thing we can do in Europe, in terms of addressing this, is to get the top line turned around in European Retail. Our Contract business in Europe is actually performing pretty well. It's, in terms of sales growth, comparable to what we're seeing in North America.

Operator

Your next question comes from the line of Joscelyn MacKay with Morningstar.

Joscelyn MacKay - Morningstar Inc., Research Division

I just have a couple of quick questions on your share purchase activity and potential maybe use of leverage. I know that we've spoken in the past, and you guys do plan on paying down the debt that is due in 2012 and 2014 in connection with the Corporate Express acquisition. But I'm just wondering if perhaps with shares at such an opportunistic level, if you might consider kind of taking on some debt to help fund that share repurchase activity.

Ronald L. Sargent

John?

John J. Mahoney

Yes, I think we've been pretty clear on our priorities for our cash flows. We want to continue to invest in the business. We want to maintain a good credit profile that allows us to have flexibility for opportunities in the future. And we'll use the cash flows that we generate over and above those that we need to invest in the business to return cash to shareholders. Clearly, we've been much more aggressive in buying back shares than we planned at the beginning of the year, and we'll wind up spending more than what we originally planned throughout the rest of the year. Our view has been that typically little value is added with accelerated share repurchase programs or leveraging the balance sheet to do that. We think that there's marginal benefit or incremental benefit, I'll say, in trying to use the capital structure to drive value. And there's transformational value in investing in things that will make our business more relevant to our small-business customers. As Ron said, the small-business environment is tough right now, not much capital available for them. So we believe that many of the things we're investing in as small business improves, we'll see significant acceleration as we build the capabilities to meet those small business customer needs. We think that, that's more valuable than borrowing money to buy back shares. So I don't expect to see us to borrow money to buy back shares.

Operator

Your next question comes from the line of Scott Tilghman with Caris & Company.

R. Scott Tilghman - Caris & Company, Inc., Research Division

Wanted to touch on a couple of things. We've hit on Europe and Australia quite a bit. Just wondering where your thinking lies on Asia right now, just sort of broader trends near-term, and then longer-term opportunities, if your thinking has changed at all versus where it was a year or 2 ago. And then related to that, if I can speak, just more broadly speaking, it sounds like a lot of the focus really is more cost management rather than revenue driving in the near-term, and justifiably so. But I'm just wondering if you're seeing any low-hanging fruit out there that might be an easy pickup on the revenue side.

Ronald L. Sargent

Sure. Mike?

Michael A. Miles

I think we continue to feel Asia is an important future long-term growth idea for Staples. And we're seeing nice growth in India. And our China business has improved profitability significantly over the last couple of years. Our focus in both of those markets right now is on not only growing the business, but also getting the business model and the customer proposition right. And in both markets, we see very low gross margins relative to the rest of the world. That's to be expected. But I think we need to figure out a way to get those a little bit higher than they are, to have a business that we feel like we can really grow rapidly. And I think before we really push our foot down on the gas pedal on either of those markets, we'll want to make sure that we've got a business model that we'll be happy to have when it scales. With respect to revenue driving in International, you're right. Obviously, the focus right now is on improving profitability, and the tough economy makes us even more focused on that. But I do think we see significant opportunities to drive the delivery business in most of our markets. I think the mid-market initiative that I mentioned during the first part of the call should be a great lever for us across Europe and also in Australia, where we have a much more enterprise-driven Contract business than what we have in North America. And as I think you probably know, that mid-market business is the thing that really drives the superior profitability of our North American Delivery business. We also have an opportunity to improve our online business significantly. Our International business that's more in the direct space is much more of a catalog business than what we've got in North America. And there's a tremendous opportunity for us to improve in the dot-com space.

R. Scott Tilghman - Caris & Company, Inc., Research Division

That's helpful. Let me ask one follow-up just related to Australia. You have good scale in Europe and in the U.S. that helped promote efficiency. Do you feel like you have that same scale in Australia? Or would a small fold-in acquisition to build scale there be helpful.

Michael A. Miles

We've got great scale actually, Scott, in Australia. Given the size of the market and the size of our business there, we've really got a terrific platform nationwide, continent-wide that we can build on. Acquisitions might be one way of doing that. But as I said, I think the sales growth that we can drive from the mid-market and the dot-com space, which we can run through our existing supply chain, is the best opportunity.

Operator

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

Kelly Chen - Telsey Advisory Group LLC

This is actually Kelly Chen for Joe Feldman. As we're looking at the SG&A dollar growth rate, you guys seem to manage that really well, and it's kind of tracked a lot lower than it has in the past 2 quarters. So I know that you guys are still investing in growth initiatives, but you're also starting to lap some of those investments. So we're just wondering if the lower rate of dollar growth is sustainable year-over-year. How should we think about that as you're trying to balance growth with a challenging top line environment?

Ronald L. Sargent

John?

John J. Mahoney

Yes, again, I think the idea that we're trying to invest in our growth initiatives as rapidly as we can absorb the capital and P&L spending against those is something we plan to continue to do. Our third quarter, I think, saw an awful lot of good things happen, but I would expect to see us continue to invest at rates similar to what we have on the average of the last 4 quarters, say.

Kelly Chen - Telsey Advisory Group LLC

Got you. And then another question that we had was, as we look at the gross margin, especially for the next 2 quarters, I know that last year, you guys had -- it was a little bit more promotional and some of that was driven by weather. But what's your strategy? And how you think about it going into this year?

John J. Mahoney

Well, again, I think that, yes, you're absolutely right. Last year in the fourth quarter with challenges with weather and being overstocked on some technology purchases, we were extremely promotional in January and that hurt our gross margins materially. So we would expect to see an improvement on that in the fourth quarter this year. Longer-term, I think that the trends that we're seeing -- a more attractive technology business that has attachments and services as a more important part of it; the growth of the Copy & Print business, which has higher margin rates; continued advancement in development of Staples' brand products -- all we think will allow us to see improvement in our gross margin longer-term. There's some trends that cut against that, as we think about some of the categories that earn lower margins, like tablets and PCs versus some of the traditional surge protectors and printer cables and so forth. But I think on the whole, the balance is towards seeing an uptick in margins.

Ronald L. Sargent

And we certainly expect to see better weather in January.

Kelly Chen - Telsey Advisory Group LLC

Yes, we certainly hope so. So just to clarify then, excluding kind of the structural shifts from the higher margin businesses, from just the core business, even if -- whether it might not be as favorable, would you say you're less inclined to be as promotional, given what you saw last year?

Ronald L. Sargent

Yes, I think that's fair.

Operator

And with no further questions at this time, I would now like to turn the call over to Mr. Ron Sargent for closing remarks.

Ronald L. Sargent

Thanks, everybody, for joining us on the call this morning. We appreciate your time. And sorry about the conflict with the Home Depot conference call. We'll try not to do that again in the future. And we look forward to speaking to all of you again very soon.

Operator

Thank you for joining today's conference. That concludes the presentation. You may now disconnect. Have a great day.

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