Staples Q2 2007 Earnings Call Transcript

Aug.21.07 | About: Staples, Inc. (SPLS)
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Staples, Inc. (NASDAQ:SPLS)

Q2 2007 Earnings Call

August 21, 2007 8:00 am ET

Executives

Laurel Lefebvre - IR

Ronald Sargent - Chairman, CEO

Mike Miles - President, COO

John Mahoney - CAO, CFO

Joe Doody - President, NAD

Demos Parneros - President, U.S. Superstores

Analysts

Danielle Fox - Merrill Lynch

Colin McGranahan - Sanford Bernstein

Michael Baker - Deutsche Bank

Mitch Kaiser - Piper Jaffray

Matthew Fassler - Goldman Sachs

Brian Nagel - UBS

Chris Horvers - Bear Stearns

Jack Murphy - William Blair

Joe Feldman - Telsey Advisory Group

Gary Balter - Credit Suisse

Brad Thomas - Lehman Brothers

Daniel Severa - Koch Capital

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2007 Staples Incorporated earnings conference call. (Operator Instructions) I would now like to turn the presentation over your host for today's conference, Ms. Laurel Lefebvre, Vice President of Investor Relations. Please proceed, ma’am.

Laurel Lefebvre

Good morning, everyone and thanks for joining us for our second quarter 2007 earnings announcement. During today's call, we'll discuss some non-GAAP metrics, such as return on net assets, to provide investors with useful information about our financial performance. Please see the financial measures section of the investor information portion of Staples.com for an explanation and reconciliation of such measures, and other calculations of financial measures that we use to analyze our business.

I would also like to remind you that certain information contained in this call constitutes forward-looking statements for 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 or elsewhere in Staples' latest 10-Q filed today.

Here to discuss Staples' second quarter 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 America Delivery.

Ronald Sargent

Thanks, Laurel and good morning, everybody. This morning I'm pleased to report another quarter of solid earnings growth of for Staples. Once again our North American delivery business led the way with strong top line growth coupled with steady margin improvement. Our effort to build a profitable international business continues to pay off with strong year-over-year performance as well, and although we were disappointed with sales in our North American retail business, we managed our expenses tightly in order to grow operating income.

I would like to recap some of the high level results for the quarter and then turn it over to Mike. Our earnings per share were up 14%, to $0.25 and sales grew 11% to $4.3 billion. The good performance of both the top and bottom lines reflect strong expense control, balanced with investments to drive growth. Our North American retail business again experienced softer than expected sales during the quarter with same-store sales down 2% and total sales up 5%, which led to only a modest increase in the bottom line. Our North American delivery business continued to gain market share with top line growth of 16% and operating income of 18%. Finally, we're happy with the strong improvement we're seeing in our international business, where total sales were up 18% in U.S. dollars. That's 11% in local currency. Same-store sales grew 7% and operating margin jumped 225 basis points to 1%.

So while we were very pleased with our results in North American delivery and international, it's clear we're operating in a tough retail environment in North America. Given that, we're going to stay committed to growing our business profitably by focusing on the levers that we can control. This means we'll continue to focus on the basic nuts and bolts of retail operations, it means we'll be working on merchandising and marketing programs to drive traffic and we will maintain disciplined expense controls. At the same time, we'll also continue to make investments to drive the top line in existing businesses, as well as develop new growth platforms for the future.

I'll now turn it over to Mike Miles to talk about the second quarter results in North America.

Mike Miles

Thanks, Ron. Good morning, everyone. Let's start with the results for North American retail. Sales for the quarter were $2.1 billion, up 4.9% versus Q2 of 2006. Same-store sales were down 2% against a 4% comparison in Q2 of last year. The comp reflects lower average order size and slightly negative customer traffic. We had strong growth in copy center, laptop computers, ink and software, but these gains did not make up for negative comps in furniture, supplies, and tech durables.

Operating margin declined 33 basis points and operating income was up slightly to $157 million. The decline in operating margin reflects tighter expense controls that were not enough to offset weaker sales and investments in new store growth and marketing. We're not satisfied with our results this quarter and we're working hard to turn our performance around. Obviously, we'll continue to manage expenses in-line with sales; at the same time, we will invest in initiatives that will drive customers into our stores. For example, our new loyalty program launched in April gives customers 10% back in rewards on their purchases of ink and toner, paper, and copy center, the products our core customers purchase most frequently. Paper is seeing a benefit from the rewards program and we're also doing a good job targeting the right paper for the right uses for our customers and driving higher price points as a result.

Another good example of our efforts to stimulate customer traffic is our focus on ink, the largest category in our stores. Through a combination of 10% savings for rewards customers, discounts on multi-pack purchases, and $3 back on recycled cartridges, customers can realize significant savings on their ink purchases. The market has responded well to our compelling value message, great assortment, and in-stock guarantee, fueling growth in this key category.

High-margin services are another avenue of long-term growth for Staples. Our in-store copy centers are still growing strong, and we're always adding to our service offering. Most recently, we introduced business cards and minutes in all of our stores. Staples is the first national chain to offer this service exclusively, allowing our customers to get custom business cards made while they wait. Our in-store centers are not the only growth opportunity for these services. Our three small format copy and print shops in the Boston market are ramping well and we will have several more open in New York City later this year.

Finally, we completed the infrastructure build out for our Staples Easy Tech program this quarter. Every store now has a dedicated Staples Easy Tech work area fully outfitted with an Internet connection and tech tool kit. Staples Easy Tech continued to ramp nicely during the quarter.

We've also done a lot to bring customers into our stores during the back-to-school season, so that we can improve on last year's strong performance. This year we focused on the latest colors and styles with a coordinated collection of fun, back-to-school products in supplies, technology, and decor. While back-to-school has always been a highly promotional season, we do not see it as being any more so this year and believe our merchant team has developed a unique product offering that will differentiate us from our competitors and drive traffic into our stores.

Looking beyond the back-to-school season, we've developed a number of new merchandising initiatives to reinvigorate our product and service offering. Let me highlight just a couple of the things that we're doing to spice up our in-store merchandising.

In September we're launching a major cross-category initiative to help customers protect themselves from information security threats. We'll make it easy for our customers to prevent data loss, viruses and identity theft by offering an innovative assortment of security-related products and services, including data storage, antivirus, software, and shredders. In addition, our Staples Easy Techs will be able to provide installation services on customer's computers.

Also, building on our successful Staples brand, we will introduce M by Staples, which is a higher end, high-quality line of office supplies for customers who want distinctive value. We will have 35 SKUs in the fall, including notebooks, journals, bags, and portfolios.

We're also continuing to invest in steady, consistent square footage growth and are maintaining our measured pace in opening new stores and entering new markets. We're on track to open over 100 stores in North America this year. During Q2, we opened 28 office superstores, versus 13 for the same period last year. We're filling in Chicago and south Florida, we've just entered the Denver market where we now have eight stores open, and we're looking towards some of the other major markets that we have yet to enter. At the end of the quarter, we had 1,672 stores open in North America.

Clearly results in North American retail during the second quarter were not satisfactory. However, it's a tough retail environment and we're continuing to execute well, gain market share, and invest for long-term growth.

Moving to North American Delivery, the NAD team delivered terrific results and really carried the load this quarter. Sales grew 16.1% year over year to $1.6 billion in Q2. Our organic growth of 13% was driven by strong customer acquisition in all segments of the market. Staples Business Delivery was the standout performer in the segment with impressive top and bottom line improvement.

Operating income increased 17.6% to $168 million or 10.7% of sales, a 14 basis point increase from last year's second quarter. Significant reductions in logistics costs achieved by implementing process improvements, eliminating rework, and improving service efficiency helped drive our increased margins in North American Delivery. In addition, our gross profit also benefited as the fulfillment centers we opened in 2006 ramped up productivity. These improvements to the supply chain were partially offset by the integration of the American Identity acquisition, high growth in contract, and investment in our sales force and copy facilities.

North American Delivery achieved double-digit growth in many of our major product categories. Share of wallet initiatives in new categories such as Jan/San continue to grow nicely and Mail & Ship experienced rapid growth, boosted by our acquisition of Chiswick. We're making great progress integrating our American Identity acquisition and by this fall we'll be able to offer logo merchandise to all of our contract customers. Geographic expansion aided by new retail market entries also helped our growth during the quarter.

In addition to focusing on customer acquisition, emphasizing share of wallet initiatives, and making tuck-in acquisitions, we're continuously improving logistics and customer service to drive customer retention. In July we started shipping product from our newest fulfillment center, the tri-channel facility in Denver. We also opened a new fulfillment center in Nova Scotia to complete our national coverage in Canada. We now have 31 fulfillment centers, including six tri-channel facilities supporting our delivery business.

Our newest call center will open in Baton Rouge next quarter, bringing the total number to seven in North America. Because of investments in supply chain and customer service, key operational metrics such as trips per order, customer service calls, and vendor on-time performance are at their best levels ever. Our contract call centers were recently recognized by JD Power and Associates for customer service excellence for the fourth consecutive quarter. Our Staples business delivery call centers have just received this distinction for the third consecutive year.

Increasing Internet penetration is another key to driving customer satisfaction. Worldwide ecommerce sales in the second quarter were $1.3 billion, a 20% increase year over year. In Q2 electronic sales represented 89% of total sales in our contract segment and 75% of sales for North American delivery overall.

In summary, we're pleased that our North American delivery business continues its sales momentum and rapid market share gains. The combination of our experienced management team, consistent strategy, differentiated sales model and success in integrating acquisitions gives us the confidence that we will be able to maintain our mid-teens growth well into the future.

With that I'll turn it back over to Ron to talk about international.

Ronald Sargent

Thanks, Mike. International sales for the second quarter were $602 million. That's up 18% in U.S. dollars and 10.5% in local currencies versus Q2 of last year. SBU income increased $4.4 million or 0.7% of sales and that was a 225-basis point improvement over last year's Q2 results.

In international retail, we're pleased with our overall profit improvement and strong comps of 7%; that was driven by increased traffic across all countries. We're particularly happy with the progress in the U.K. where our continued focus on customer service, delivering a strong offer, and great execution drove above average sales comps, as well as customer traffic. We're also making good progress, improving profitability throughout retail. As one example, we've dramatically expanded Staples brand products in Europe, introducing over 200 own brand products this quarter alone.

In the U.K., our focus on direct sourcing and own brand development over the last 12 months has driven sales penetration equal to that of U.S. retail. One new store was added in Europe and one closed in Europe during the quarter and we ended Q2 with a total of 266 stores.

On the delivery side, the operating margin rate in Europe improved more than 200 basis points year over year with strong top line growth in the U.K., Spain, Italy, and Scandinavia. JPG, our French delivery business, representing more than half of European delivery sales, continues to improve its top line thanks to a new website, increased own brand penetration, improved systems, and continued success in our preferred customer programs.

Our businesses in Asia, also making great progress with China growing even faster this year than last and both Beijing and Shanghai, our position as one of the exclusive suppliers to the 2008 Beijing Olympic Games helped drive our incremental sales as well as margin. In the Jiangsu province, we opened seven new stores this quarter, bringing the total number of Staples branded retail stores in China to 24. Looking ahead, we're ready to begin delivery operations in Shenzhen later this month.

Our joint venture in India is off to a good start. In July we began selling office products to contract customers in all major cities and we expect to begin retail operations in India later this year.

In summary we're encouraged by the strong results on both the top and bottom lines in Europe as well as our rapid growth in new markets. We're confident that we're on the way to achieving our operating margin goal of 7.5%.

Now I would like to turn it over to John Mahoney to review the numbers.

John Mahoney

Thanks, Ron. I'll go through the financials and explain what's driving our results before wrapping up with some guidance for the third quarter and the full year. Total company sales of $4.3 billion were up 10.6% versus last year's quarter, excluding the foreign currency benefit, sales grew 9%. Gross profit margin decreased by 5 basis points to 28.21% during the quarter. This reflects improvement in distribution expense in North American delivery driven by efficiencies in our fulfillment center network as we anniversary the three new FCs we opened last year.

We also increased margins in our European business. These improvements were offset by a decline in product margin rate in both our North American delivery and retail businesses due to mix and deleverage of rent and occupancy as a result of the negative comp in North American retail. Operating and selling expenses for Q2 improved 27 basis points versus last year's second quarter at 16.87% of sales.

Each of our three segments contributed to the strong performance. Our international segment achieved solid cost savings and benefited from the robust sales growth they saw. North American Delivery made nice headway and productivity improvements in marketing and in customer service. And we were impressed by North American Retail's efforts, as the team was able to get modest leverage on operating and selling lines, despite soft sales, thanks to tight expense controls.

Turning to general and administrative expense, G&A as a rate of sales was up 18 basis points year over year at 4.72%. This increase includes investments in information systems and our new shared services center in South Carolina. Equity compensation was also a significant factor due to a shift in mix of our equity plans towards more restricted shares and fewer stock options, as well as an increase in compensation expense related to our businesses in China.

Moving on to the balance sheet, total inventory turns were down 5 basis points versus last year to 5.72 turns as improvement in North American Delivery supply chain were offset by slower sales in North American Retail. At the end of the second quarter, Staples had $1.7 billion in liquidity including cash and short-term investments of $857 million and available lines of credit of about $845 million. On August 15, we paid off $200 million in senior notes, so our cash position has been reduced since the end of the quarter. Return on net assets for the year improved to 14.4%, up 120 basis points compared to the end of the second quarter a year ago.

During the second quarter, our board of directors authorized the repurchase of up to $1.5 billion of Staples common stock. This new share repurchase program replaces another previously authorized $1.5 billion share repurchase program. We repurchased 8.1 million shares for $198 million during the quarter and have about 1.4 billion remaining on our new authorization. Our diluted weighted average shares outstanding declined by just under 18 million shares year over year for the quarter as a result of our repurchase program, offset by stock option exercises.

Year-to-date CapEx came in at $206 million, down from the $254 million we spent in the same period in 2006, largely due to decreased investment in fulfillment centers that was partially offset by an increased investment in new stores. With operating cash flow of $219 million, we generated $13.9 million in free cash flow year-to-date versus negative free cash flow of $125 million in the same period last year. For the year, we expect approximately $550 million in capital expenditures and more than $700 million in free cash flow.

Looking ahead, we do not anticipate that the weak sales growth we saw in North American Retail during Q2 will turn around significantly in the third quarter. In Q3, we expect low double-digit top line growth overall. This implies slightly negative to flat comps and mid single-digit sales growth in our North American retail business, mid-teens sales growth in North American delivery, and low to mid single-digit retail comps and high single-digit sales in local currency in international.

We can mitigate much of the impact from weaker sales through expense reductions and expect EPS growth of approximately 15% for the quarter, excluding the one-time items from last year's third quarter. For the full year, we expect low double-digit overall sales growth with flat comps in North American Retail. We maintain our previous EPS guidance of approximately 15% for the full year, adjusting for the one-time items and the 53rd week.

Thanks for your time this morning. Now I'll turn it back over to our conference call moderator for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Danielle Fox - Merrill Lynch.

Danielle Fox - Merrill Lynch

I was wondering if you could talk about why you think supplies were weak at North American retail, since that would seem to be one of the more nondiscretionary categories. Is there anything specific going on with the supplies part of the business?

Ronald Sargent

The headline is traffic, but let me ask Mike.

Mike Miles

Yes. I think that's right, Ron and Danielle, that traffic in the stores, although it was modestly just slightly negative for the quarter overall, was boosted by some of our back-to-school traffic and supplies over the course of the quarter were affected by traffic from our core customers, particularly in May and June. That's a trend that we seem to be seeing across the board and it's the reason that, as John said, we're fairly conservative in our thinking about North American retail for the balance of the year.

Danielle Fox - Merrill Lynch

What effect are we seeing the credit markets have on some of the small business spending? Clearly, you've had very, very good results at the delivery business, so you're not seeing any slowdown there, but how do you think about the effect of what we're seeing in the credit markets might have on small business spending and how do you monitor it?

Ronald Sargent

John, do you want to take that one?

John Mahoney

Yes. I think [technical difficulties].

Operator

One moment, ladies and gentlemen. The conference will resume shortly. One moment. You may resume.

John Mahoney

Hello, Danielle and sorry. We didn't dislike your question.

Danielle Fox - Merrill Lynch

I thought maybe it was just too hard a question or something.

John Mahoney

We just lost power. Something to do with the credit markets.

Danielle Fox - Merrill Lynch

That's how they are saving.

John Mahoney

I was about three-quarters of the way through a brilliant answer. I think what I was starting to say, Danielle, is I'm not so sure that it's availability of credit that's really the key for small business. It isn't like some of the larger businesses that require rapid access to the public markets. I do think, however, that small business, their confidence is impacted by the things that go on. You mentioned that supplies aren't a discretionary purchase, but you certainly can defer the purchase of supplies. Maybe you don't keep your supply closet as full or you make less purchases than the amount you'd otherwise make. I think it's that confidence opposed to the availability of capital – at least right now -- that's causing the slowdown for small business customers.

Operator

Your next question comes from the line of Colin McGranahan - Sanford Bernstein.

Colin McGranahan - Sanford Bernstein

First question, I really wanted to focus on the retail business. Obviously that was the weak part of the report here. Can you talk about what you calculate your self-cannibalization to be and any change there? I'm sure that you're looking at competitive incursion from the accelerated store growth. If you could quantify that, what you think that is and how you've seen stores react as new competitors have come in? If you can talk about that portion and then if there were any major regional differences within the comp and any changes in marketing or advertising that might have had an impact on the traffic?

Ronald Sargent

I'll ask Mike Miles to answer that one, Colin.

Mike Miles

First of all, cannibalization from our own stores runs something less than 100 basis points, as does cannibalization from competitive stores. That's something that hasn't changed significantly over the last couple of years. It's up a little bit as the number of stores has increased, but it's not the reason that, if we were at a 4 comp last year, this quarter we're at a negative 2 this year this quarter. It's something that's an everyday thing that we deal with in the business and I don't think it's changed significantly.

In fact, when you look at markets like Dallas and Seattle, which are two of the more recent markets that we've entered that are among the most competitive in terms of new store builds, those are two of our best comping markets. So I don't think we can pin the blame for the comp on saturation or new store activity.

From a regional basis, we were sort of down across the board. There are a couple of markets, namely Florida and Arizona that have been down significantly, particularly from where they were last year and are at the relatively low end of our numbers. I think that has probably something to do with what's going on in the housing market.

Colin McGranahan - Sanford Bernstein

In terms of the G&A and the deleverage there, it sounds like some of that maybe was kind of one time and nonrecurring, with the exception maybe of, it looked like there was a 25% increased in stock-based compensation, and you talked about China. Can you just talk about your ability to leverage G&A on a 10 to 11% top line growth and was the stock-based compensation at all a factor of increased volatility impacting option values? I know you had mentioned the shift towards restricted stock. Was that actually an increase in incentive comp? If you can maybe address the G&A portion?

John Mahoney

I think we believe that we will be able to leverage G&A with the kind of sales growth that we've seen. It's one of the things that we work very hard at and you're right, the stock-based compensation is something that is new this quarter, relating mainly to our associates in China where the stock-based compensation that they receive is based on the performance of their business unit, and as a result they've had great success and so we've seen a big jump in the value of the stock compensation that they receive. We won't expect to see that continue.

I think we mentioned also the investment in information systems. A lot of that has to do with projects that we completed in the past and the depreciation related to those, as well as a number of software licenses where we had in previous years agreed that for the first several years of the new system we would not see license fees and we'd begin to pay some of those this year. Again, all of those things, we expect, will drive productivity in the G&A areas, and therefore we will see leverage, certainly at the level of 10% to 11% sales growth.

Colin McGranahan - Sanford Bernstein

Finally, what was the FX impact on NAR sales?

Ronald Sargent

We're looking it up, but as you know, the Canadian dollar has appreciated.

Colin McGranahan - Sanford Bernstein

Yes. It looked like the new store productivity numbers were exceptionally strong, but my guess is that there was an FX impact in there.

Ronald Sargent

There certainly was an FX impact.

John Mahoney

Yes. It was maybe less than 1%.

Operator

Your next question comes from Michael Baker - Deutsche Bank.

Michael Baker - Deutsche Bank

My question is probably more of a bigger picture macro question. If you look at your delivery business, the small business customer still spending, if you look at retail, not so much. So which do you think is the true picture of the economy? Then is it just share gains in the delivery that's leading to your growth, and then are you therefore losing share in your retail business? Thanks.

Ronald Sargent

Let me take a stab at that one and, John, you can add if you like. Last quarter at this call I said I was cautious about the consumer and I think this quarter I'm probably a bit worried about the consumer. Worried is probably a better word, these days, than cautious. Certainly, consumer spending seems to be slowing. You look at mortgage rates rising, real estate prices are falling. Cost of driving and energy are going up. Really, throughout retail, retail sales are soft. It's not just us, but I think other retailers as well. So I think the headline there is that consumers are buying less stuff as they're nervous about the future, and probably as they have less dollars in their pocket.

On the other hand, when you look at the business sector, that continues to be pretty healthy. Job growth is okay. You got GDP and industrial production is starting to trend up and when you look at our delivery business, we're doing just fine. It seems to me what we're seeing is more of a consumer slowdown than a business slowdown and that obviously affects your retail stores. Given your delivery business is primarily business driven, I think that is part of our success there.

Having said that, I think we are gaining share, certainly in our delivery business and even when you look at our retail business, when you look at a lot of the data, we're gaining share in I don't remember the number, but it was 34 out of 41 categories that we track, I don't think we're losing share in either retail or delivery, but I do think there is some sort of a consumer and very, very small business slowdown going on, on the retail side.

Michael Baker - Deutsche Bank

That makes sense. Then just one more quick follow-up. I didn't quite understand what you said about back-to-school. How are the trends in the back-to-school product in particular over the last couple weeks or so?

Mike Miles

We're obviously very early in back-to-school and there's been a shift of schools to later in the quarter, so July was probably fewer people going back to school than there were a year ago. The comment I was making was our back-to-school promotional strategy is a very traffic intensive strategy. We do a lot of hot buy promotions with penny prices and that has a tendency to drive a fair amount of traffic into the stores. That's what helped our traffic number get to be as close to flat as it was in the second quarter. During May and June, traffic was probably a little softer than it was for the quarter overall.

Operator

Your next question comes from Mitch Kaiser - Piper Jaffray.

Mitch Kaiser - Piper Jaffray

I think on the first quarter call you talked about potentially stepping up marketing in the second quarter, I was wondering if you could just talk about the results of that? Do you plan to do that towards the back half as we've seen weaker traffic trends?

Mike Miles

We're trying to step up the marketing, particularly to our core business customer, small business customer, and shift a little bit of money from television, a little bit of money from some of our sports marketing type of campaigns, from pretty much everywhere that we can get it into more direct marketing against small businesses. I would say that we've gotten a little bit of that done in the second quarter, we've got more planned in the third quarter and the fourth quarter, so we will have to let you know how it goes, but that's definitely a part of our strategy, is to get more of the right kind of traffic into our stores and probably cut back a little bit on some of the longer-term brand-building type of advertising that we need to keep doing, but may not have the luxury in the kind of comp environment we're in right now.

Mitch Kaiser - Piper Jaffray

So does that appear to be the weakness in retail small business versus consumer, or is it difficult to disaggregate the two?

Mike Miles

We're seeing weakness across the board, but small business weakness is the one that we're more concerned about, honestly, because that's where we make all of our money. I think Ron's comments about the consumer are reflective of the comp overall and we're working hard to not just chase comp, but to chase profitable sales and the profitable sales we get are from small business and home offices.

Mitch Kaiser - Piper Jaffray

Lastly, I think you were talking about inventory coming down as the year progresses. Now with slightly reduced top line growth for retail, do you still expect inventory levels to come down more towards square footage growth?

John Mahoney

Yes. I think that we have a couple of factors. We do build our inventories for back-to-school, so this is a seasonally high period for us when we talk about our cash flows for the year, you'll notice that cash flows year-to-date are fairly positive free cash flows and we expect strong cash flows for the year typical of our seasonal pattern. In addition to that, as a result of planning for sales that were more robust than what we saw in North American retail, we do have more inventory, not inventory that we're concerned about selling or that causes obsolescence, but it's a bigger investment in inventory than we had planned.

Operator

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

Matthew Fassler - Goldman Sachs

A couple questions on delivery. First of all, if you look at delivery over the past couple of years, your sales growth is essentially holding the levels that you had seen, your operating margins are going up, but at a somewhat reduced clip, so it sounds like you're getting a little less leverage for the mid to high teen sales growth that you're delivering. Can you talk about what you think is behind that and what kind of margin opportunity you still see in the delivery business?

Joe Doody

Matt, first of all, you commented on the consistency of the sales growth. That's true. We're now at about 11 quarters where we've had 14% or more top line growth and at the same time, we're also now at 14 quarters consecutively that we've grown earnings faster than we've grown sales.

If you look at your point about gaining less ground or having it not grow as fast, more recently we have made some significant investments here and even in this past quarter, to continue to ensure future growth in our business. So those investments were things like the American Identity acquisition, our new retail channels, incremental salespeople within our contract business, our contract copy centers, our Staples Industrial business, and all of those were over 50 basis points of a hit that we used for investment in our business for future growth. So we're pretty confident that we're driving to continue to keep that high top line sales growth while continuing to grow the bottom line faster than sales.

Matthew Fassler - Goldman Sachs

Joe, as you think about those various investments, do you see their impact kind of lingering through the second half of the year?

Joe Doody

There will be some, yes, because American Identity is one purchase that was just recently made. It's at a lower profit rate that will continue to have an impact on us for the next several quarters.

Matthew Fassler - Goldman Sachs

Can you remind us in the second quarter what the organic growth rate was in delivery of the growth, ex acquisitions, please?

Joe Doody

Yes. Ex acquisitions it was 13% growth.

Matthew Fassler - Goldman Sachs

Where had that been in Q1, if you recall?

Joe Doody

Q1 was 14% ex acquisitions.

Matthew Fassler - Goldman Sachs

One final question on retail. You commented on Florida being one of the tougher markets. My sense was that you had a pretty successful new market entry in south Florida as you'd ramped up in Miami, Fort Lauderdale, et cetera. Can you put that into context about what you said about the Florida market overall?

Mike Miles

Matt, I was talking about our comp markets like Orlando and Tampa, not Miami. The Miami market launch, the Miami, Fort Lauderdale launch is off to a great start.

Operator

Your next question comes from the line of Brian Nagel - UBS.

Brian Nagel - UBS

First, with respect to retail, last year you beat many of your competitors to market on the back-to-school promotions. The sense was this year that many of them went earlier. Any way to quantify, to say that shift, what impact that may have had on your comps in Q2?

Ronald Sargent

That's a little bit of a tough one, because back-to-school is always a pretty aggressive promotional time of the year and then we had several school districts in the South or a lot of school districts in the South pushing their back-to-school a week later. It's a little hard to give you much color on that one.

Brian Nagel - UBS

The other question, also with respect to retail, this is an issue we've looked at before, but as you look at your business or as you look at your customers, particularly those that cross shop among the different channels, any evidence suggest that more shifting to the delivery channel away from retail?

Ronald Sargent

We always get asked that question internally when we have not so great retail comps. When we have good retail comps, that question never comes up here in internally. The answer is, there are some cross shoppers and we have a great delivery offering and we have a great, easy website for people to use, but the amount of cross shopping that occurs is probably less than you think. We would like it to be more because if they shop in multiple channels, they tend to spend more but it's kind of in the 10% to 12% range of customers who shop both channels. It's really not a distinct customer segment. I don't think that's the issue with our same-store sales, although, like I said, it comes up occasionally when comps are not so good.

Mike Miles

Just to add on to that, I would add that one of the things that is helping our Staples business delivery business in particular is the new market entries and you see SBD's growth in Chicago, Denver, and Miami is significantly higher than it is as a multiple of what it is overall and it's obviously pretty healthy overall. So that interaction between the two businesses is definitely a positive.

Brian Nagel - UBS

Very good. One final question with respect to international, you guys have made great progress over the past few quarters in improving the results there. If you look at the improvement, if we break it down, how much of it reflects your internal initiatives versus, say, improving economies in that region?

Ronald Sargent

I think some markets in Europe, the economy is in pretty good shape, but I would say any improvement that we're seeing in international, we're doing a better job just executing our business day to day. I probably should make a note, though, that you won't see this kind of comp performance in the second half because I guess a couple of things.

One is we've got easier comparisons in the first half than we had in the second half. If you look at last year comps, we were 1% in the first half, I think we were 5% in the second half. Our comp rate will come down. Then the other thing, last year you had kind of a heat wave in Northern Europe, which probably depressed our sales and you had even the World Cup, which probably depressed our sales. I don't see the 7% comp continuing on for the remainder of the year. It will come down for the second half.

Operator

Your next question comes from the line of Chris Horvers - Bear Stearns.

Chris Horvers - Bear Stearns

Mike alluded to this a little bit, but what were your comps were by month during the quarter?

Ronald Sargent

Sure. I can just give you a general sense. I don't want to get into the point where we're reporting monthly comps, but we had a pretty good April to wrap up the first quarter; and then May, the first period of our new quarter started weaker; and then we saw some improvement in June and July. But you look at this thing week to week, it's been very choppy, sometimes up, sometimes down. It's really hard to kind of call a trend based on our second quarter performance.

Chris Horvers - Bear Stearns

You do imply some acceleration in 3Q on the comp side, both sequentially and looking on a two-year basis. Is it the back-to-school shift and the timing of school openings that's part of that rationale.

Ronald Sargent

It's really more initiatives. Mike talked about some of the merchandising initiatives, the marketing initiatives. We expect to continue to give great service in stores and all of those things, we believe, will cause some improvement. Back-to-school certainly is a period of time that's important to us will be an important part of the third quarter, but overall it's not expecting a change in the market, but much more reflecting the initiatives we've identified to drive sales throughout the rest of the year. We're focused on playing our own game.

Chris Horvers - Bear Stearns

On the retail side, operating margins were very expensive on the cost control. Can we somehow describe how long you could maintain expense control and not show cost deleverage pressure in those retail margins in this comp environment?

John Mahoney

I think the way we look at it is over some longer period of time, there are a lot more costs that are variable than they are in the short run. We plan our year with a certain amount of latitude around what we can expect for sales and gross margin dollars. We have certainly, Demos has tested the limits of what our team can accomplish in our store business, but we would expect that these are not just one-time things, deferring costs and other things like that.

These are managing expenses on a day to day basis to the level of sales that we achieve. It's very difficult for the team, they deserve a lot of credit for the great job that they have done, but it is something that's sustainable. If we expected sales to be at this level forever, we'd look more fundamentally at our fixed versus variable cost structure. We don't think we have to do that based on the fact that we think this will be temporary.

Chris Horvers - Bear Stearns

So then anything about flattish comps in the back half of the year, you could sustain this cost control and the operating margin?

John Mahoney

That's correct.

Chris Horvers - Bear Stearns

Finally, curious, given your loyalty card, have you tried to look at your spending at retail on the small business side and try to figure out, well, X percent of our customers or growth and our revenues has been from mortgage brokers or local real estate agents, someone connected to the housing market?

Ronald Sargent

I don't know if we've cut it by SIC code or not, Mike?

Mike Miles

Well, we do. I haven't specifically seen anything on whether the real estate or housing segments are significantly down. I think it's probably a pretty good assumption that they are based on the rest of what we're seeing.

Operator

Your next question comes from the line of Jack Murphy - William Blair.

Jack Murphy - William Blair

Another question on the rewards program, now that you've got a few months into it, are you getting the type of customers by size that you had expected to sign up and also the type of usage that you thought you'd get? Secondarily, are there any surprises, positive or negative on the margin impact of the program?

Ronald Sargent

I'll answer the second question first and the answer is no, it's been according to our expectations, it's not been a cost increase over the prior program that we've got.

With respect to the first question, we're seeing the right kind of penetration improvement of the rewards program on the categories that we're focused on, but obviously we're not seeing the overall impact on the store that we want, so we're looking at that program real hard for ways that we can drive more traffic and again specifically, business customer traffic out of it. It is definitely a rich area for us in terms of the number of business customers that we can communicate with regularly, but when you look at our comps overall, obviously the rewards program change has not been enough to turn things around.

Jack Murphy - William Blair

But the targeted rewards program customer, is it still stronger than that casual consumer?

Ronald Sargent

Yes. Our core rewards customers are our best customers and they continue to perform the best, but we're not getting enough of the lift from that program that we need to get us into positive comps.

Jack Murphy - William Blair

One last question for John, probably. On the buyback, could you talk a little bit about your disposition toward being more aggressive on the buyback given the strong cash flow and obviously the price of the stock?

John Mahoney

I think our strategy has been not to be a market timer. We're in the market every day, we buy stock back consistently as a way to return cash flow above that that we can invest in the business to our shareholders and I would expect to maintain that posture.

Operator

Your next question comes from Joe Feldman - Telsey Advisory Group.

Joe Feldman - Telsey Advisory Group

Can you discuss the competitive environment? I know you addressed a little in the call earlier, but just anything that you're seeing differently from the competition and also any impact from the commodity pricing environment?

Ronald Sargent

Let me ask Joe and Demos to talk about the competitive environments. They're the most closely affected by it. Joe you want to start with the delivery side?

Joe Doody

From a delivery standpoint, it's always a pretty aggressive marketplace out there, especially true with the larger customers and I think in the last quarter or so, we've probably seen the most aggressive position taken among Fortune 500 customers, the larger ones. So we have not played as aggressively in that marketplace, we'll walk away from business in that marketplace. In fact, our contract business to our largest customers has showed the lowest growth over many quarters in this most recent quarter.

So we're still continuing to go after customers that value our offering, looking at total lowest delivered cost and we're very satisfied with the growth that we're seeing, but from a competitive standpoint, it's probably as aggressive as we have seen it in the past quarter or so.

Demos Parneros

On the store side, I think it's safe to say that in both competitor or superstore competitor cases, that they've come out with the same early back-to-school approach that it seems like everyone is doing this season. There's not a whole lot of different activity in our new market. It's a pretty rational environment in a lot of the new store openings that we've done, so not a whole lot different out there in terms of their activity.

Ronald Sargent

Pricing?

Demos Parneros

I'd say we're all competitive for back-to-school. I'd say in new market entries, it's fairly consistent with what the marketplace is.

Joe Feldman - Telsey Advisory Group

One other question. With regard to the small business customer, and I think you guys touched on it again earlier, but are you seeing a shift towards the delivery business for out of retail? I mean I understand that there's concern about the small business customer and I guess when you say small business, you're thinking really the small guys, but it just doesn't make sense in this environment, that at least everything, the macro data that we hear, we understand the consumer pressure, but given your focus on the business customer, just that's where I'm having a little issue I guess.

Ronald Sargent

The only thing I could tell you is that, I think if you're a one-person business or a two-person business, you tend to act a little more like a consumer than you do as a business. As I said earlier, if we can get all of our retail customer shopping in delivery, we'd be thrilled because they tend to spend more in retail and in delivery if they shop in multiple channels. I think in our retail business, most of our retail business customers are less than ten office workers and a lot of them have one office worker and that's the person who's running the business. I think they're having the same pressure as the consumers are having.

Joe Doody

From a delivery standpoint, the very core of our customers are more the ten customers on up. We have a very proven and successful model to go after medium-sized businesses that is helping us to show great sales growth and great market share growth.

Operator

Your next question comes from Gary Balter - Credit Suisse.

Gary Balter - Credit Suisse

Not much left to ask, but I'll point out one thing. This is two quarters in a row, first of all, that you haven't blamed Canada for your bad results.

Ronald Sargent

Let me think about that. I'm sure there's something we can say about Canada.

Gary Balter - Credit Suisse

A question is, I'll ask two questions and I'll let you go, is, the gross margins look like they were down about 40 bips at retail just with our math and Mike had commented earlier that the competitive environment and the pricing environment stayed pretty much the same, so what caused the margin decline?

Ronald Sargent

I think it's probably mix driven as much as anything. John?

John Mahoney

Yes. It's almost exclusively mix. We've seen much more demand in categories that aren't as margin rich, primarily in tech and we've talked about the comp strong categories, the tech categories were our strongest categories, so it's almost exclusively mix coupled with the way we account for promo money, which I guess absorbed in the inventory, when the inventory goes up, so there's some promo affect as well.

Gary Balter - Credit Suisse

Second, following up on the buyback question, you mentioned that you're on a consistent program and you don't do market timing, but you're sitting with a lot of cash and your stock looks to be at a somewhat depressed level, has there been some thought to just raising the overall level of buyback on a consistent basis, given all the cash you've got?

John Mahoney

I think it's always a consideration. We always talk about it and certainly given the volatility and the uncertainty in the stock market, I would be the last one to try and predict where the stock market is going to go. We think the company is a great value, as we always do, it's a company that we expect to grow and create value for shareholders over the long run. We dial it up and dial it down on a daily basis based on the specific trading, but within very narrow parameters and we expect that the benefit that we get is by taking a fairly set number of dollars, we'll get more shares on the price as well and we think that it fits in with our overall capital strategy as we've explained it.

Operator

Your next question comes from the line of Brad Thomas - Lehman Brothers.

Brad Thomas - Lehman Brothers

Thanks. I think most of my questions have been answered as well, but maybe I could just follow-up with one more on the North American retail. I know you said furniture, supplies, and the tech durables were some categories that were a little bit weaker, but were there any surprises, any categories or products that really came in and surprised you, or do you think the weakness was primarily due to the softer traffic?

Ronald Sargent

I can't think of any categories, furniture is an interesting one, because furniture, we're doing very well with some of the new furniture items on the delivery business, but we're not doing as well on the retail business. I'm not sure if the furniture business is good right now or bad right now. Certainly it's bad in retail good in delivery. I can't think of any single category that jumped out at us as being terribly surprising.

Brad Thomas - Lehman Brothers

Just a follow-up on delivery, I know you don't beak out or quantify the breakdown between new accounts and share of wallet, but could you maybe talk about, have there been any trends over the last couple of quarters in terms of the mix as a driver of sales and even stepping back over the last couple of years, has there been any change in terms of how those two have broken down as a contributor to your sales growth?

Ronald Sargent

My guess is we're seeing growth if both. I know we're seeing big growth in acquisitions, but I will ask Joe to answer that one.

Joe Doody

Brad, you're right on. We've shown great growth in acquisition and in fact in the second quarter, we had our best acquisition quarter since 2004 as far as acquiring number of new accounts, so that continues to bode well for the future. But we're also seeing growth in existing business, as well as continuing high retention rates of our existing customers based on our outstanding service and support that we provide to our customers. So our logistics organization and customer service organization had a fantastic year and we expect that to continue in providing absolutely the best service that we've seen in our history to our customers.

Operator

Your final question comes from the line of Daniel Severa - Koch Capital.

Daniel Severa - Koch Capital

You explained the weakness in American retail, slow traffic. Can you explain the strong part of American retail in copy and print centers, laptop computers, ink, and software?

Mike Miles

Those have been areas of focus for us. Ink is one of our critical businesses that's better than 20% of our store sales and we've worked really hard to drive that with a strong value message and we are pretty confident based on syndicated data that we're gaining share in that category. The copy center, the same way. It's been an area of focus for us over the last three years. We've worked really hard to be a great value player in that space. As well, we've introduced the business cards in minutes program, as well as other things like wide format color that are increasing our breadth of offerings and in that space, we're very clear we're gaining share as the leading competitor in that space was down 2% last quarter and we're up very significantly.

The same is true with laptop computers. We improved our store layout on that last year and as a result both with the hardware specifically and also the attachments that go with them, we've had significant increases in sales. So we just need more categories like that where we're able to bring great value and news so that we can get the comp up overall. But those categories, the focus categories have been very strong for us.

Daniel Severa - Koch Capital

Okay. So it's purely market share gain and not a strong industry category?

Mike Miles

Well, I think the first two that's true, ink and copy center is market share gain. The laptop areas, I think we're gaining a little share in a very strong category from an industry standpoint.

Ronald Sargent

Daniel, we're clearly not happy with our retail sales, but I think our plan is not to chase comp sales at the cost of our earnings targets. As Mike said, we're going to continue to make investments for the future while at the same time growing earnings 15% and our job is to continue to gain share no matter what the economy does.

Daniel Severa - Koch Capital

How are your paper sales within retail?

Ronald Sargent

Paper sales are good, although you had three increases in the cost of paper last year and you had another one the 1st of May. Certainly, sales are good as a result of the cost increase. I think tonnage is also pretty good as a result of our rewards programs.

Operator

There are no further questions at this time. I would like to turn the call back over to Ron Sargent for closing remarks.

Ronald Sargent

Just to wrap up, I would like to thank the Staples team for again delivering good results in a pretty challenging quarter. Despite the tough retail market, our business remains fundamentally strong and we expect to achieve our growth goals. I believe that our ongoing investments in projects as well as people are creating a better customer experience that will continue to drive market share gains. Thanks everybody for your time this morning. We look forward to talking to you again soon.

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