OfficeMax Q3 2007 Earnings Call Transcript

Nov. 1.07 | About: OfficeMax Incorporated (OMX)

OfficeMax (NYSE:OMX)

Q3 2007 Earnings Call

November 1, 2007 9:00 am ET

Executives

John Jennings - SVP, Treasurer and Investor Relations

Sam Duncan - Chairman and CEO

Don Civgin - Chief Financial Officer

Analysts

Steve Chick – JP Morgan

Brad Thomas - Lehman Brothers

Mitch Kaiser - Piper Jaffray

Colin McGranahan - Bear Stearns

Chris Horvers - Bear Stearns

Matt Fassler - Goldman Sachs

Seth Basham - Credit Suisse

Operator

I would like to welcome everyone to the OfficeMax thirdquarter 2007 earnings conference call. (Operator Instructions) It is nowmy pleasure to introduce you to John Jennings, SVP, Treasurer and InvestorRelations of OfficeMax, Inc. Mr.Jennings, you may begin your conference.

John Jennings

Good morning, everyone and thanks for joining us today. I’m here with Sam Duncan, our Chairman andCEO and Don Civgin, our Chief Financial Officer. Sam and Don will provide detail of ourfinancial and operating performance for the third quarter of 2007.

Before I turn the call over to Sam, I have a fewadministrative items. Today’s conferencecall will be archived on our website for one year following that call. Note that this call may not be rebroadcastwithout prior written consent from OfficeMax.

In addition, please note that during this call we willdiscuss non-GAAP financial measures. Weevaluate our results of operations both before and after certain gains andlosses that management believes are not indicative of our core operatingactivities. We believe our presentationof financial measures before or including these items which are non-GAAPmeasures, enhances our investors overall understanding of our recurringoperational performance and provides useful information to both investors andmanagement to evaluate the ongoing operations and prospects of OfficeMax byproviding better comparisons.

Whenever we use non-GAAP financial measures, we designatethese measures which exclude the effect of certain special items as adjusted,and have provided a reconciliation of non-GAAP financial measures to GAAPfinancial measures in our press release today.

Some statements made on this call and other written or oralstatements made by or on behalf of the company constitute forward-lookingstatements within the meaning of the federal securities laws, includingstatements regarding the company’s future performance as well as management’sexpectations, beliefs, intentions, plans, estimates or projections relating tothe future.

Management believes that these forward-looking statementsare reasonable; however, the company can not guarantee that it willsuccessfully execute its turnaround plans or that its actual results will beconsistent with the forward-looking statements, and you should not place unduereliance on them.

These statements are based on current expectations and speakonly as of the date they are made. Thecompany undertakes no obligation to publicly update or revise anyforward-looking statements whether as the result of future events, newinformation or otherwise.

Important factors regarding the company which may causeresults to differ from expectations are included in the company’s annual reporton Form 10-K of the year ended December 30, 2006 and included under the caption Cautionary and forward-LookingStatements in item 1(a) of that form and in the company’s other filings withthe SEC.

As always, after the call today, please feel free to call mewith any follow-up questions. It’s nowmy pleasure to turn the call over to Sam Duncan, Chairman and CEO of OfficeMax.

Sam Duncan

Good morning, everyone. Thank you for joining Don Civgin, our Chief Financial Officer, and me onthe call this morning. Today Don and Iwill review OfficeMax’s third quarter 2007 performance and I will update you onsome of our 2007 initiatives as they relate to our Q3 performance and to thepriorities we’ve set early this year.

We are in the process of preparing our 2008 operating planand we look forward to sharing more details of that plan with you early nextyear. Overall, for the third quarter of2007, our results showed progress within the framework of our turnaround plan,even while we navigate a weaker economic environment that has had some impacton both our contracts and retail operating segments.

In our retail segments, we are disappointed with the bottomline decline in the third quarter, reflecting our need to reaffirm ourpriorities for profitable growth and cost controls. However, we are pleased with the third quarterimprovement in our contract segment bottom line as we address some negativetrends we experienced during the first half of the year.

For the third quarter of 2007 compared to the prior yearperiod as adjusted, total sales grew 3.2% to $2.3 billion; operating incomemargin improved 30 basis points to 3.9%; net income increased 16% to $49.9million; and earnings per share increased 14% to $0.64 per share.

In our contract segment, we experienced gross margin declinein the third quarter versus last year, but improvement from the first half of2007. From the third quarter of 2007compared to the prior year period as adjusted, contract generated operatingincome margins of 4.6%, up 70 basis points by offsetting gross margin declineswith improved operating expense as a percent of sales.

For our UScontract, which represents about 75% of our total contract sales, weexperienced a 1.9% decrease in sales in Q3 versus the prior year aftergenerating year-over-year growth during the first half of 2007. The decline in Q3 sales versus the prior yearreflects lower sales from existing accounts, which we believe is due to asofter, more cautious economy.

In addition, our decline in Q3 US contract sales versusprior year reflects our initiatives to increase discipline and are ramping upnew accounts versus the first half of 2007. These sequential declines in US contract sales in Q3 versus the firsthalf of 2007 also reflects our decision to terminate a contract with onesignificant large account that started with us in December of 2006.

Our contract segment gross margin in the third quarter of2007 was 22.1% down 20 basis points from Q3 last year, primarily due to lowerbilled gross margin rate in large UScontract customers, partially offset by reduced delivery costs.

While our contract gross margin in Q3 continues to benegatively impacted by higher paper prices versus last year, we were able topass through more of these price increases to our customers than during thefirst half of 2007.

Our third quarter contract operating margin expansionreflects actions we took in UScontract throughout 2007 to improve profitability from existing customers andfrom new or renewing customers.

For existing large customers, our centralized team pursuedvarious win-win tactics with our customers. Some of these tactics included increasing private label sales andnegotiating manufacturer price increase or cost to serve options. Other activities included reviewingunprofitable accounts and pursuing appropriate actions to improve profitabilityor developing an exit strategy. Theseexisting customer tactics contributed materially in improving our contractgross margin rate sequentially from Q2 to Q3 in 2007 by 70 basis points.

The action plans we implemented for US contracts alsoimproved how we bring on new and renewing large customers, to avoidunprofitable sales. Specific tacticsinclude centralized pricing control, better analytics, improved accountabilityand more discipline in approving contracts. As we have discussed previously, the impact of these initiatives islowering new account sales growth, but better performance.

In the third quarter compared to the second quarter of 2007,sales from new accounts decreased about 8% but gross margin rates wereapproximately 190 basis points higher. As most of you are aware, one of our 2007 priorities has been costcontrol and we have made significant progress in reducing both our UScontract delivery cost sales and operating cost.

As part of our UScontract reorganization, we aligned delivery operations under supplychains. This drove efficiency byleveraging our transportation assets better through higher utilization of ourprivate fleet and creating higher productivity in both delivery and warehouse.

On the operating expense side during Q3, we benefited fromour sales reorganization including lower sales payroll cost as a percent ofsales; lower US contract operating costs contributed significantly to our totalcontract segment operating expense as a percent of sales improvement of 90basis points in Q3, compared to the same period last year as adjusted.

For our UScontract reorganization including supply chains delivery and operating costimprovement, we estimate total savings of at least $10 million on an annualizedbasis in 2007.

Looking forward, we plan to use our cost to serve initiativesto improve our customer experience, another 2007 priority. We are pursuing incremental improvement incontract operating margins by redefining our customer proposition and aligningour services such as delivery frequency and minimum order sizes with what ourcustomer truly need.

We are also continuing to rationalize our product offeringwith more emphasis on meeting customer requirements for product selection. Specific tactics include increasing privatelabel sales in contract, negotiating a set of core products to optimize accountperformance, and refining our stocking strategies.

While our private label percent of total UScontract sales has increased 400 basis points in Q3 to 31%, it still representssignificant opportunity. These tacticsare part of our strategy to lower cost for our customers while generating betterprofitability for OfficeMax.

As we have discussed throughout our turnaround, one of ourobjectives is to expand our percentage of contract sales from the middle marketcustomers. The middle market is very attractive, representing potentially $50billion in sales in the USand generating gross margin that can average 500 to 1000 basis points higherthan a typical large contract customer.

Through our contract reorganization in 2007, we decreasedour overall salesforce headcount by about 15%, but we increased the number ofmiddle market sales hunters. While our reorganization has challenged our middlemarket sales growth in 2007, inQ3 we began to see positive trends from our new sales teams, and we believemiddle market remains a huge opportunity. Our goal is to grow annual sales fromthe middle market at double-digit rates in each of the next two years.

Summarizing the contract segment initiatives from 2007,which has been driven by our core turnaround strategy, we remain focused onmanaging profitable sales growth from large customers, targeting improved grossmargins from continued cost containment, and enabling aggressive middle marketsales growth for the future.

Moving to our retail segment, third quarter performancereflected a weaker spending environment with softer sales from ourhigher-margin categories and increased technology category sales. This resultedin a shift of our sales mix and produced lower gross margins that we were notable to offset with cost reductions.

For the third quarter of 2007, retail generated operatingincome margin of 4%, down 100 basis points year over year. Our same-store salesincrease of 0.8% showed relative strength, given the weaker consumer and smallbusiness spending environment.

For the key back-to-school season, sales were up about 1%,but customers were more responsive to promotional offers than last year, perhapsreflecting the impact of the USeconomy on purchase decisions. This year’s back-to-school sales season shiftedto later in the quarter as school openings adjusted, resulting in improvedsales trends in late August and September.

Looking at specific category performance for retail in thethird quarter, our technology category, which represented 50% of Q3 retailsales, generated positive same-store sales from computers, digital cameras andprinter supplies, but weaker sales from business machines. We have experienced growth in technologysales throughout 2007 versus last year reflecting trends in the USfor computer products but also reflecting improvements we’ve made in our PC andlaptop category management.

Our furniture category, which represented 9% of Q3 retailsales, experienced negative same-store sales in Q3, reflecting some executionissues with assortment. Our supplies andpaper category represented about 41% of Q3 retail sales and includes ImPress, ourpress and document services.

Within supplies, we experienced negative same-stores salesfor Q3 with the back-to-school season growing moderately, offset by declines inour core office supply categories for the full quarter.

OfficeMax ImPress produced same-store sales growth in themid single-digits for Q3 while our growth in the recent quarters improvedImPress sales to our contract customers. While growing off of a small base, we continue to build print anddocument service relationships with our contract customers and believe it hassignificant potential. While it isdifficult to quantify the impact, we believe the negative same-store sales weexperienced for core supplies, ImPress and furniture in Q3 reflects weakness inoverall consumer and small business spending in the US.

Retail gross margin declined to 28.9% in the third quarterof 2007, down 120 basis points versus last year, primarily due to the impact ofa shift in the mix of sales to a higher percentage of technology category salesat lower gross margin rates, and a lower percentage of sales in core officesupplies and furniture which typically generate higher gross margin rates.

For the third quarter of 2007 compared to last year, retailsegment operating expense as a percent of sales improved 20 basis points to20.9% in Q3, but this was not enough to offset our retail gross margindecline. To address the Q3 operatingmargin decline in retail, in the near term we are adjusting our promotionalactivities and expenses in light of more cautious shopping trends by retailconsumers and small businesses.

The holiday outlook in November and December of 2007 is forweaker sales growth than last year, according to economic forecasts. We will continue to adjust our promotionalactivities, align our marketing plans and aggressively pursue cost savings.

As with contract, private label is also a critical retailinitiative that continues to grow in 2007 with potential for gross marginimprovement. For the third quarter of2007 about 19% of our retail sales were private labels, excluding our servicesbusinesses, but including paper. Thisrepresents an increase of 200 basis points from the third quarter last year. Weremain under-penetrated in many categories, including commodity and premiumoffice supplies, technology, accessories and some furniture.

Private label is attractive, with gross margin ratesestimated at 700 to 1,000 basis points higher than a brand equivalent incertain targeted categories. We see ouropportunity to increase private label productivity with additional brand expansionsand better direct and domestic sourcing.

We are also continuing to pursue our 2007 priority of costcontrol in retail, both through targeted cost reductions and cost leverage ofstore expenses as a percent of sales. Weplan to generate cost leverage from sales growth as our new stores become moreproductive. Our strategy is to openstores mostly in existing markets to leverage fixed costs, utilizing existinginfrastructure and raise the overall profitability of key markets.

Typically, our new stores are modeled to reach profitabilityin year two and reach mature sales levels by year five. Since the beginning of 2007, we have beenusing more robust analytics to identify optimal new-store locations and tomodel performance expectations. Weremain on track to open another 40 to 45 domestic stores in the fourth quarterof 2007 for about 60 total new domestic stores for full year 2007.

Longer term our real estate plan includes a five-year growthstrategy using inhouse real estate expertise to identify sites, design,construct and open stores in accordance with our five-year plan.

Another important part of our real estate strategy is ourmulti-year plan to remodel stores to our Advantage store prototype. In thethird quarter, we remodeled a test of ten stores in Colorado,California and Florida. We are evaluating results, improving ourremodel processes to reduce cycle time for completing remodels, and valueengineering our investment for the best return.

In summary, the 2007 retail initiatives which are part ofour turnaround strategy include plans to address a softer selling environment,managing gross margins through effective promotional strategy and categorymanagement, controlling and leveraging expenses, and improving our real estateposition through new and remodeled stores.

At this point, I’d like to turn the call over to Don Civginso he can review additional details for the quarter.

Don Civgin

Thank you, Sam, and good morning, everyone. For the third quarter of 2007 on a GAAPbasis, OfficeMax generated net income of $49.9 million or $0.64 per diluted share compared with net income of$31.4 million or $0.41 per diluted sharefor the same period last year. Netincome for the third quarter of 2007 increased 16.6% compared to adjusted netincome in the third quarter last year of $43.2 million or $0.66 per diluted share.

Private sales for the third quarter of 2007 were $2.32billion, an increase of 3.2% compared to the same period a year ago. Contract segment sales for the third quarterof 2007 were $1.19 billion, an increase of 2.4% compared to last year.

US contract sales decreased 1.9%, primarily due to lowerlarge and middle-market customer sales as well as from lower sales in our smallmarket direct business from our continued reduction in catalog circulation tocut costs.

In our international contract operations which include ourbusinesses in Canada, Australia and New Zealand, we increased sales 16.2% in USdollars or 4.3% in local currency for the third quarter of 2007 compared to thesame period a year ago. Retail segmentsales increased 4% in the third quarter of 2007, driven by new store openingsnet of closed stores and same-store sales growth of 0.8%.

At the end of the third quarter of 2007, we had 36 net newstores opened in the USand 14 net new stores opened through our joint venture in Mexicocompared to the end of the third quarter of 2006.

Total gross margin for the third quarter of 2007 was 25.4%compared to 26.1% in the third quarter of 2006, reflecting lower gross marginin both contract and retail. In contract,our gross margin rate declined in the third quarter of 2007 to 22.1% comparedto 22.3% last year, but improved sequentially versus the first half of 2007.Retail gross margin declined to 28.9% in the third quarter of 2007 compared to30.1% last year.

Total operating expense for the third quarter of 2007improved to 21.5% of sales from 22.4% in the third quarter of 2006 as adjusted,reflecting reduced expense as a percentage of sales in both contract and retailsegments. Part of our improved operatingexpense as a percentage of sales in the third quarter of 2007 is due to lowerincentive compensation cost across our contract, retail, and corporate andother segments as we reduced our expected incentive compensation payoff for2007.

Contract segment operating expense improved to 17.5% ofsales in the third quarter of 2007 versus 18.4% in the prior year period, asadjusted. The contract operating expenseimprovement was primarily due to effective cost management in UScontract, the lower incentive compensation costs, as well as expense leveragein international contracts.

Our contract segment operating expense improvement in thethird quarter of 2007 included a $2.9 million write-off of software in our internationalcontract operation.

As Sam stated earlier, the retail segment operating expenseimproved by 20 basis points in the third quarter of 2007 to actually 24.9%versus 25.1% in the prior year period, primarily due to the lower incentive compensationcost, partially offset by higher store labor costs. Our corporate and other operating segmentsincludes support staff services and other expenses that are not fully allocatedto our retail and contract segments.

Corporate and other operating expense in the third quarterof 2007 decreased $8.8 million to $10.0 million versus $18.8 million in thethird quarter of 2006 as adjusted, primarily due to lower incentivecompensation costs and reduced legacy company expenses.

Total operating income in the third quarter of 2007 improvedto $90.2 million or 3.9% of sales from adjusted operating income in the thirdquarter last year of $81.7 million or 3.6% of sales. Operating income improvement was driven byhigher operating income in contract and improved corporate and other segmentoperating expense, partially offset by lower operating income in retail.

Moving to the balance sheet, we ended the third quarter of2007 with inventories $88.9 million higher than at the end of the third quarterlast year, primarily due to our store growth year over year and an increase ininternational contract inventory due to foreign currency exchange rates.Inventory turns current decreases to 6.6 in the third quarter of this year from 6.9 turns in thethird quarter of last year, primarily due to higher inventory levels and lowerturns from new stores as they ramp up productivity.

Accounts payable ended the third quarter $7.6 million higherthan the third quarter of 2006, primarily reflecting the timing of vendorpayments, including back to school and holiday inventory purchases.

We ended the third quarter of 2007 with accounts receivable$220.4 million higher than the third quarter of 2006 primarily as a result ofterminating our accounts receivable securitization program on July 12, 2007. The termination of our accounts receivablesecuritization program took place with the simultaneous restructuring of ourrevolving credit facilities. By amendingand restating our revolver, we expect increased financing terms and lower totalcosts.

At the end of the third quarter of 2007, under our amended$700 million revolver, we had $618 million available. We’re expecting no borrowings, and $82million of letters of credit issued under the revolver. At the end of the third quarter of 2007 wehad total debt, excluding the securitization notes, of $384.4 million in cashand cash equivalents of $147.4 million.

Turning to cash flow, during the third quarter of 2007 weused $9.1 million of cash from operations, a decrease of $197.9 million fromthe third quarter of 2006, primarily due to increased accounts receivable. Capital expenditures totaled $31.9 millionfor the third quarter of ‘07 and totaled $101.3 million for the first nine monthsof the year, with the largest components being new stores, capital projects andinformation technology. With remaining capital projects planned in the fourthquarter we expect our capital expenditures for full year ‘07 to total between$140 million and $150 million.

In the fourth quarter of 2007, we expect to receive a paymentfrom Boise LLC under our additional consideration agreement that we enteredinto in connection with the October 2004 sale of our paper, forest products andtimber assets. Under the terms of thisagreement, sales proceeds may be adjusted upward or downward based on marketprices for paper. Based on a 12-month measurement period ending September 30, 2007, we expect toreceive a payment of approximately $33 million from Boise LLC in the fourthquarter of 2007.

Now I will turn the call back over to Sam.

Sam Duncan

Thanks, Don. We havereviewed with you today our third quarter performance and some of the keyturnaround initiatives driving that performance. Along with these initiatives, we have madesome important management changes in our contract and retail segments in 2007to lead the next phase of our turnaround.

One critical executive appointment has been that of ourChief Operating Officer Sam Martin in September of 2007. Sam joined OfficeMax from Wild Oats and he hasheld many leadership positions and operations through his distinguished 30-yearcareer. In the short time Sam has beenobserving and leading contracts, retail and supply chain operations at OfficeMax,he’s already made important contributions.

The OfficeMax management team and board of directors arealigned in assuring we continue to pursue ways to maximize shareholdervalue. Our board continues to overseeour turnaround initiatives and our execution of our near-term action plans toaddress areas of concern. Ourexpectation is that continuing to execute our turnaround initiatives willachieve our goal of expanding operating margins and deliver value forshareholders.

We have already made progress accomplishing some of the keyelements of our long-term strategy through initiatives that contributed tomeaningful operating margin improvements in 2006 and 2007.

Now our sights are set for the fourth quarter of 2007 andplanning for 2008. While we do notprovide detailed sales and earnings guidance, we currently expect the following:

Well into 2008 we expect our performance will continue to beimpacted by a weaker USeconomic environments but will benefit from our turnaround initiatives. In our contract segment, we expect tocontinue to focus on profitable sales and improved cost structure as we gaintraction from the changes we’ve made through the reorganization this year.

In our retail segment, we expect to continue to focus onoperating margin expansion from top line sales growth, merchandising initiativesand cost controls, and for 2008 we currently expect to open up to 60 newdomestic stores. We expect to provideyou additional details of our 2008 performance drivers at an OfficeMax investorday and webcast in early 2008.

This concludes our prepared remarks. Now we’ll open the call up for questions.

Question-and-AnswerSession

Operator

Your first question comes from Steve Chick – JP Morgan.

Steve Chick – JPMorgan

Good quarter under the circumstances, I think. Your decline in UScontract sales year-over-year of 1.9% or so, what’s the dollar value of thelarge account that you voluntary cut business with? When exactly did that start in the quarter?

Sam Duncan

Steve, we originally started that contract in December oflast year and we ended it around July of this year. We’ll have to verify that and get back to you.It was a large account and I won’t tell you the exact denomination but it was avery large customer that was just not productive right out of the chute afterwe signed it.

Operator

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

Brad Thomas - LehmanBrothers

I just wanted to dig a little deeper into the retail grossmargins. I know you had said that mixwas the primary reason that the margins were down. But I wonder if you could just talk a littlebit more about what’s going on beyond just the mix? Is it the merchandise margin?

Sam Duncan

Brad, what it is, is first of all the technology side ofit. We just got back into computers inthe past year or so and unfortunately the computers don’t have a very highgross margin. In fact, sometimes you’relucky to breakeven. We were hoping toachieve a certain attachment rate of peripherals or accessories to go alongwith those computers and we did not achieve that. Consequently it hurt our margins. We’ve gotto continue to work on getting a better attachment rate onto our computersales.

What we are seeing in the retail side is just more cherry-pickingfrom customers. The customers are verysavvy and very smart and that was very evident in back-to-school. We would see customers come in with liststhat had four or five different retails on them with the items that they wereto get at each location.

We just have to, as we would always want to do, work on ourmerchandising in the stores to improve both the sales and margin side. But those are the two big things that hurt usin Q3.

Brad Thomas - LehmanBrothers

As we look ahead to the holidays, any specific marketing ormerchandising initiatives you think could help you in the fourth quarter?

Sam Duncan

Well yes, we’re looking at that and analyzing that. Hopefully we can find ways to help improveour performance on the retail side. Theeconomic conditions do not look bright compared to the information that we’reseeing, so that’s a concern. I thinkeverybody is saying this is supposed to be like the worst holiday season in fouror five years, and that concerns us. We’re concerned with what we saw in back-to-school with the cherry-picking. We’re aggressively looking at ways to offsetthat or try to offset that if that continues.

Operator

Your next question comes from the line of Mitch Kaiser -Piper Jaffray.

Mitch Kaiser - PiperJaffray

I was curious about the CapEx guidance for the year. I think before you had said maybe slightlybelow $180 million. You’ve continuedwith your store guidance of doing $40 million for the fourth quarter. Could you just say what’s changed in yourthinking?

Don Civgin

Really from the beginning of the year, Mitch, we’ve cut backthe remodel program pretty dramatically, and that’s been the reason the numberhas dropped from $180 million to $200 million down to $140 million to $160 million we’re talking about now.

Mitch Kaiser - PiperJaffray

I know you did ten remodels in the quarter. What are you seeing differently that’s causedyou to pull back or pause on that a little bit?

Sam Duncan

We did that, as I said in the comments, because we wanted tomake sure that we get all our processes in place and to get the valueengineered; everything, all of the equipment and everything. This company has not done remodels in a longtime and so we just didn’t have the processes in place.

We are going to do remodels in ‘08, and we’ll probably do alot of them. We’ll give you the detailsat the end of the year, but I will tellyou when we said we were going to open 60 new stores, my anticipation is, is todo equal that amount of remodels or more.

Mitch Kaiser - PiperJaffray

if you look at the chain, how many stores do you think wouldhave to be remodeled at this point or would you like to remodel?

Sam Duncan

All of them.

Mitch Kaiser - PiperJaffray

Fair enough. On thecorporate expenses, you continue to make some nice headway there. I guess, the comp is what it is. But on the legacy-related costs, are therestill opportunities there to take corporate expenses out, do you believe?

Don Civgin

Over the course of the next year or two, Mitch, there wouldstill be some opportunities to do that, but it’s come down pretty dramatically,so I think the rate of improvement will decline.

Mitch Kaiser - PiperJaffray

Lastly, I guess the tax rate dipped down this quarter. Couldyou just comment on the reason for that? I know you’re not into providing guidance, butcould you give us some clarity for what we should expect for the fourthquarter?

Don Civgin

Sure, the resolution of some audits and some other mattersbasically let us free up some reserves. So I think the fourth quarter number,everything else being the same that we’d be comfortable with is theyear-to-date percentage.

Mitch Kaiser - PiperJaffray

In terms of the contract that you exited, were there anycosts associated with getting out of that contract that you would haverecognized in the third quarter?

Sam Duncan

Well your costs are just what you had to start it up and tostop it. I don’t believe we had any write offs for that agreement.

Mitch Kaiser - PiperJaffray

Okay, thanks guys. Good luck.

Operator

Your next question is a follow-up question from the line ofSteve Chick - JP Morgan.

Steve Chick – JPMorgan

Don, can you give maybe a little more details and granularitywith the reduction in the incentive-based compensation? Why that was reduced? Itseems like maybe you’re on with your internal plan, and I don’t know if you canassign the amounts that might have helped the quarter, and how that’s going tolook as the year goes on.

Don Civgin

Without getting into what our internal plan is or isn’t, Ithink it’s no surprise, based on some of the things we’ve said earlier, thatwe’re not happy with the performance this year, and we would have hoped to dobetter. I think the decrease inincentive comp that you’re seeing in the third quarter is a reflection of that.I mean we’re not accruing bonuses at the same level, clearly, that we did lastyear with our performance last year. That’s really the reason the incentivecomp has come down.

It’s a meaningful number this quarter. It’s truing up three quartersworth to get us to the right year-to-date accrual, but it does have to do withperformance being below expectations for the year, but that should be nosurprise based on our earlier comments.

Steve Chick – JPMorgan

Given it’s a true-up, it might be kind of important for usto maybe know what -- it is in corporateoverhead as well as both your segments.

Don Civgin

Yes, it is in both the segments, and it’s in the highsingle-digits in millions.

Steve Chick – JPMorgan

Going into the fourth quarter, we kind of had this type ofrun rate?

Don Civgin

I mean, that depends on the performance in the fourthquarter. So we’ll have to see.

Steve Chick – JPMorgan

The reason why I was asking about the contract that you gotout of, I don’t know if that was one that kind of shifted back to CorporateExpress. But by my math, it seems likethat’s the type of contract that could have weighed on your UScontract business by 100 basis points. Is it as material as that?

Sam Duncan

I’ll just say, Steve, it’s a very large account. The quarter that we signed it, it cost usmoney on the operating income side. Soyes, you’re going to lose on the sales side, but we’re going to pick it up onthe op income side.

Steve Chick – JPMorgan

I wanted to see if I was directionally right with mymath. Don, the $33 million paymentyou’re expecting from Boise in thefourth quarter, is that a return of capital type of payment where your bookinvestment is now going to go down? Oris it income?

Don Civgin

First of all, yes, we do expect that right around the end ofthe year. It will be income. But it would obviously not be ongoingoperations either.

Steve Chick – JPMorgan

So what’s on your books stays the same? The book value that you have in your balancesheet of $175 million, that doesn’t change?

Don Civgin

Yes.

Steve Chick – JPMorgan

Don, you mentioned in international you had some softwarewriteoffs of $2.9 million.

Don Civgin

Yes.

Steve Chick – JPMorgan

Should we look at that as something that’s a little bit notreoccurring and somewhat unusual? Whatexactly were the activities there?

Don Civgin

It was a piece of software that they had worked with forsome time. I think this quarter it was determined that itreally was inappropriate that it be on the books at this point. So it’sclearly not something that’s happened earlier in the year. It is unusual which is why we pointed itout. It’s a pretty substantial number.

Sam Duncan

That was a purchase of software that was made approximately fouror five years ago.

Steve Chick – JPMorgan

That’s not something that happens obviously every quarter,so it seems like something obviously non-reoccurring.

Operator

Your next question comes from the line of Colin McGranahan -Bear Stearns.

Colin McGranahan -Bear Stearns

First, you commented on adjustments to the promotional andmarketing activities going forward in regard to the environment. Can you just maybe more broadly talk aboutwhat you did and what you saw during the third quarter? To any degree thatyou’re comfortable with and knowing obviously this is a very competitive areaas we are coming into the holidays, but what you meant by promotionaladjustments and alignments.

My second question would be just on your five-year, yourlong-term store growth strategy, I’m not sure that you’ve ever given us anyinsight into that. Is the 60 that youdid this year, the preliminary prep plan for next year, is that a level ofabsolute number of store openings that we should pretty much just assumethrough that five-year plan?

Sam Duncan

Colin, we haven’t disclosed that yet, but those are numbersthat look pretty safe. I guess I would say going forward they couldchange, but we have yet to get board approval on some of the things and we willfinalize that and go over it with you at the beginning of next year.

On the promotional adjustments, again in the back-to-schoolseason when we saw 4 cherry-picking going on from consumers than we’ve seen inthe past, so promotional adjustments, what we mean by that is looking at ourads. Historically in this business youdon’t run ads every single week. Youhave what we call dark weeks where there’s no ads. We look at opportunities. If there’s any opportunity just to go dark onsome weeks in every quarter, and we’re hearing that.

Also, we’re reviewing the items that we’re putting into adsto make sure that with all the cherry picking going on, we may reduce the itemsor look at the pricing that’s in there and not go quite so deep because of thecherry-picking going on to save some markdown money. So that’s what we mean by promotionaladjustments.

Colin McGranahan -Bear Stearns

Cherry-picking, it seems to us that’s an outcome of a moredifficult consumer environment. So wouldyou address that by instead of promoting individual items going to like a 5%off your purchase strategy or something like that to try to avoid that cherry-pickingbehavior?

Sam Duncan

Well, we look at everything. I’m not sure percentage offs work a great deal, but I know what you’resaying. But we will take a look at justabout anything and try to be creative where we can get customers in our storesbut limit our markdown.

Colin McGranahan -Bear Stearns

Would you say the overall intensity of the promotionenvironment in the third quarter apart from this cherry-picking behavior wasany different?

Sam Duncan

We saw more aggressiveness in the promotional activity.

Operator

Your next question comes from Chris Horvers - Bear Stearns.

Chris Horvers - BearStearns

I wanted to follow up on the intent of Tom’s question. What factors drive incentive compaccruals? It sound like you made areversal true-up in 3Q. I think it’sprobably lower 4Q and then for a part of next year. But what factor should we think about? Is it return on sales? Is it EBIT rate? So on and so forth.

Don Civgin

First of all, I don’t know that we’re talking about 2008here. I mean we’re talking about 2007incentive plans so the part about next year is not right. But as it relates to the third quarter andagain what we’ll do in the fourth quarter we have a variety of incentivetargets obviously better disclosed to some extent in the proxy, but we have avariety of incentive targets internally which we measure against. Based on our performance against those targets,we determined the right amount to accrue. That’s what we did in the third quarter and that’s what we will do againin the fourth.

Chris Horvers - BearStearns

So I am curious as to what – is it a sales return or is it aprofit rate? If you had to categorizethe biggest ones, the biggest drivers, what would it be?

Don Civgin

It is a variety of things and it’s different for differentgroups of people. I would tell you that it obviously has to dowith sales and profits.

Chris Horvers - BearStearns

Sales and profits. Onthe contract that you exited, is it easyto get out of contracts? Is therenormally, is there a timeframe where you can say, , we don’t like this after sixmonths, we can get out of it. How easyor difficult is it to exit those kind of contracts?

Sam Duncan

Most of the contracts have out clauses in them where oneparty or the other’s unhappy. They mightbe 60-day outs, 90-day outs, 120-day outs but it’s safe to say that most or allof our contract have an option out in them, and this particular contract did.

Chris Horvers - BearStearns

I may have missed this in the prepared remarks, how do youthink you performed within the middle market sequentially over the first three quartersof the year on the contract side?

Sam Duncan

Well we’re still not totally happy with it. That’s why we’re doing somerestructuring. It’s showing better signsor better trends than Q1 and Q2. I wouldhope to see Q4 better than Q3, Q2 and Q1 but that’s up to us to prove that. Ifeel good about the changes that we’ve made and the direction that we’re goingthere.

Chris Horvers - BearStearns

Are there any contracts that you’re currently reviewing andpotentially thinking about exiting in the near term?

Sam Duncan

There’s nothing on our screen or anything that indicates anyserious troubles or anything. We’re justtrying to look at how we can manage all of our contracts. There are no danger signs in any ones that wehave today like the one that we exited earlier this year.

Operator

The next question comes from Matt Fassler - Goldman Sachs.

Matt Fassler -Goldman Sachs

I’d like to ask a question on the working capital front,specifically about receivables. If youcould quantify the increase of receivables on the books as a result ofterminating the securitization program and what AR growth might have lookedlike without that change in financial structure?

Don Civgin

Matt, it’s roughly $160 million with what was added toreceivables when we took out the securitization program.

Matt Fassler -Goldman Sachs

How come we made that change?

Don Civgin

Frankly given the circumstances and the rates and thestructure, it was just more attractive for us to do a $700 million revolver andreplace the $500 million revolver and $200 million securitization. It’s basically more cost effective for the company.

Matt Fassler -Goldman Sachs

Focusing on retail and the merchandise mix, can you give ussome color on the magnitude of the supplies decline? It sounds like within that the core businesscustomer might have been a little bit softer than the consumer, but it would beinteresting if you could clarify whether you thought that was the case.

Finally as you look at the fourth quarter along those lines,do you think that the consumer is as important, more important or less importantto your fourth quarter retail sales relative to Q3?

Sam Duncan

Matt, I would say that they are equally as important. I wouldn’t downplay one way or theother. Supplies, you are correct in yourstatement. We’ve just got to figure outways to be more creative in our merchandising, meaning inside of the stores tomake our merchandise mix look more attractive and that’s what we’re doingtoday.

Matt Fassler -Goldman Sachs

Finally, if you could give us some color on your read on theproductivity of new stores and just to play devils’ advocate, this is anindustry where all three players are seeing slowing results, certainlychallenges and margin contraction. Doesthis lead you to reconsider your store growth agenda as you look to ‘08 and‘09?

Sam Duncan

No, we are not reconsidering our store growth. We feel that we’ve got opportunities to growin the areas that we’re in today, and we’re using our map and flow softwarethat we have for that. That helps us a lot to pick out what we think are verygood sites, and as I said in my remarks, we give our stores two years to reachprofitability, and I will not say that we’re unhappy with any of them at thispoint. We’re making progress.

Operator

Your final question comes from Seth Basham - Credit Suisse.

Seth Basham - CreditSuisse

Digging a little bit deeper into some of the previouslyasked questions, just thinking about the merchandising mix on the retail side,you mentioned technology being a much bigger component. By my calculations, ifit is apples-to-apples, it’s only 150 basis points larger as a percentage ofthe business this third quarter versus last, which wouldn’t suggest a hugeimpact on the margins from mix.

Maybe you can give us a little bit more granularity withinthat category how big computers were and some of the other lower margincomponents of technology?

Sam Duncan

Seth, I don’t have those numbers in front of me. That’ssomething that John maybe get back to you on. I just couldn’t answer that rightnow.

Seth Basham - CreditSuisse

At a higher level, Sam, is it more about the mix here or isit more about just a promotional environment, in your view?

Sam Duncan

Mix. You know we have to get a better attachment rate ofaccessories to the computers we sell, and hopefully not have a customer justwalk out with a laptop or a desktop and not purchase routers and hard drivesand mouses and all of those things. That’s what we saw in the third quarter isour attachment rate was not where it should have been to offset the negativityof the margin on the computers.

Seth Basham - CreditSuisse

As you think about the business machine category, which youmentioned was kind of soft, how are you inventories and your promotionalexpectations for that category, going forward?

Sam Duncan

We are happy with our inventories at this level. Inventoriesare not a problem in our company today.

Seth Basham - CreditSuisse

Lastly on the retail side, thinking about store labor. Youmentioned that it was up in the quarter, and what’s your expectation goingforward? I though the labor plan was pretty much set.

Sam Duncan

Well we adjust our labor. Yes, you have a basic labor planin any company, and you go as your sales trims are moving one way or the otheryou adjust those numbers, and that’s what we continually to do. If the sales are going down, you adjust yourlabor needs and your stores or vice versa.

We continue to look at that and look at what the needs arein our stores, and that will be the focus in the fourth quarter and we’ll lookto make sure that we make the right adjustments.

Seth Basham - CreditSuisse

John, lastly on the incentive comp question, just a followup. The reduction there for the thirdquarter also includes reversals of accruals for earlier in the year?

John Jennings

Yes.

Operator

We have reached the end of the allotted time for questionsand answers. Mr. Jennings, are there anyclosing remarks?

John Jennings

No, that’s all, Cody. Thank you very much for joining our call today.

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