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OfficeMax Incorporated (NYSE:OMX)

Q4 2007 Earnings Call

February 19, 2008 9:00 am ET

Executives

John Jennings - SVP, Treasurer and Investor Relations

Sam Duncan - Chairman and CEO

Sam Martin - COO

Don Civgin - Chief Financial Officer

Analysts

Mitch Kaiser - Piper Jaffray

Matt Fassler - Goldman, Sachs & Co.

Brian Nagel - UBS

Seth Basham - Credit Suisse

Chris Horvers - Bear Stearns

Oliver Wintermanel - Morgan Stanley

[Chris Blanton - Russell and Hazel]

Steve Chick – J.P. Morgan

Operator

Good morning. My name is [Christy], and I will be your conference facilitator today. At this time, I would like to welcome everyone to the OfficeMax fourth quarter 2007 earnings conference call. (Operator Instructions)

It is now my pleasure to introduce you to John Jennings, Senior Vice President, Treasurer and Investor Relations of OfficeMax Incorporated. Mr. Jennings, you may begin your conference.

John Jennings - SVP, Treasurer and Investor Relations

Good morning, everyone, and thanks for joining us today. I'm here with Sam Duncan, our Chairman and CEO, Sam Martin, our Chief Operating Officer, and Don Civgin, our Chief Financial Officer.

Before I turn the call over to Sam Duncan, I have a few administrative items. Earlier this month we announced that OfficeMax intends to host an investor day on Wednesday, March 19, 2008. We're planning on a morning session with several speakers from our senior management team. Invitations for the investor day were sent out last week, and please contact my office with any questions. The investor day will be webcast live, and we will announce specific details for accessing the webcast event in the near future.

Today's conference call will be archived on our web site for one year following the call. Note that this call may not be rebroadcast without prior written consent from OfficeMax. In addition, please note that during this call we will discuss non-GAAP financial measures. We evaluate our results of operations both before and after certain gains and losses that management believes are not indicative of our core operating activities. We believe our presentation of financial measures before or excluding these items, which are non-GAAP measures, enhances our investors' overall understanding of our recurring operational performance and provides useful information to both investors and management to evaluate the ongoing operations and prospects of OfficeMax by providing better comparisons.

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

Some statements made on this call and other written or oral statements made by or on behalf of the company constitute forward-looking statements within the meaning of the federal securities laws, including statements regarding the company's future performance as well as management's expectations, beliefs, intentions, plans, estimates or projections related to the future.

Management believes that these forward-looking statements are reasonable, however the company cannot guarantee that it will successfully evaluate - execute - its turnaround plans or that its actual results will be consistent with the forward-looking statements, and you should not place undue reliance on them.

These statements are based on current expectations and speak only as of the date they are made. The company undertakes no obligation to publicly update or revise any forward-looking statement whether as a result of future events, new information or otherwise.

Important factors regarding the company which may cause results to differ from expectations are included in the company's annual report on Form 10K for the year ended December 30, 2006, including under the caption Cautionary and Forward-Looking Statements in Item 1A of that form and in the company's other filings with the SEC.

As always, after the call today please feel free to call me with any follow-up questions.

It's now my pleasure to turn the call over to Sam Duncan, Chairman and CEO of OfficeMax.

Sam Duncan - Chairman and CEO

Thanks, John, and good morning, everyone.

On today's call I'll highlight our 2007 performance, and Sam Martin, our Chief Operating Officer, will detail our operating segment performance in the fourth quarter, Don Civgin, our Chief Financial Officer, will review financial details, and I will wrap up with our initial outlook for 2008.

Looking at 2007, overall we are mostly pleased with our performance for the year. As expected of a turnaround, we continued to recalibrate our strategies in 2007 as we address certain macroeconomic and execution challenges to pursue improvement across our operating segments.

Taken as a whole, 2007 continued to show progress with our turnaround. While 2007 was not a top line sales [inaudible] for OfficeMax with total revenue growth of 1.3%, it reflects our focus on profitable sales and the weaker economic environment we experienced in the second half of 2007.

Due mostly to effective cost management, we were pleased to expand our adjusted operating margin to 3.8% and grow adjusted net income by 18.3% to $188.1 million or $2.41 per diluted share.

Let's turn to some specific activities we pursued within our operating segments in 2007.

As you know, an important issue for the Contract has been the reorganization of our U.S. Contract business. The reorganization is enabling us to move from decentralized operating regions to a more cohesive U.S. Contract business, with sales and operations organized for further improvement.

We reduced our field sales headcount by about 15% in 2007, but increased the number of sales hunters. Our delivery and warehouse operations were consolidated into supply chain and now share responsibility for both U.S. Contract delivery and Retail store fulfilment.

We've already begun to realize benefits from the U.S. Contract reorganization, and we expect to generate approximately $10 million of annualized operating profit improvement.

In 2007 the reorganization helped us to move toward a U.S. Contract platform that can flex to align with our customer requirements for sales, service and products while generating incremental operating profit improvement for OfficeMax.

In Retail an important 2007 initiative was executing our real estate strategy. For the year, we opened 59 new domestic stores, relocated one store, and opened 15 new stores in Mexico. Our new domestic stores are modelled to enter profitability typically in the second year open as they begin leveraging costs from sales growth.

In 2007 we also successfully tested an additional 12 remodels in Colorado, California, Florida and Puerto Rico. Remodels transition our aging stores to the look and feel of our successful Advantage store prototype with improved merchandising and customer shopability. The results of the 2007 remodel test are expected to help us reduce cycle time for completing remodels and value engineer our investment for the best return.

Our real estate strategy will continue to be a combination of new store openings, mostly in existing markets, along with store remodels.

In 2008 we are targeting the opening of up to 40 new stores and the completion of approximately 60 remodels in the United States. We continue to identify significant opportunities for additional new stores in the United States, but made the decision to reduce our 2008 number to a new store target to maintain prudent capital investment given the weaker economic climate.

Our new stores utilize our successful Advantage store prototype and remodel [these] elements of Advantage. By the end of 2008, we expect to have about 25% of our U.S. stores either in the Advantage format or remodelled and we continue to believe our real estate strategy will be a strong driver of further improvements in Retail performance.

Before I turn the call over to Sam Martin, I'd like to briefly discuss the macro environment in the fourth quarter of 2007. The selling environment in Q4 proved to be particularly difficult as we continued to face the impact of a weaker U.S. economy that impacted both our Contract and Retail segments. Weaker trends recently reported in business, employment and consumer spending as well as Gross Domestic Product trends in the U.S. are clearly reflected in our sales trends for the fourth quarter.

We navigated this environment during the fourth quarter by managing margins and costs, resulting in bottom line improvement. While total sales decreased 2.6% to $2.2 billion in the fourth quarter, we improved operating income margin by 60 basis points to 4% and increased net income by 37.4% to $51.1 million or $0.65 per diluted share compared to the fourth quarter of 2006 as adjusted.

Now I'll turn the call over to Sam Martin to review details of our Contract and Retail operating segment performance for the fourth quarter.

Sam Martin - COO

Thanks, Sam. Good morning, everyone. I'm pleased to be here today, and I look forward to interacting with the shareholder and analyst community in the future to communicate more about our operating performance and initiatives.

Today, I'd first like to discuss some of the activities I've pursued since joining the OfficeMax executive team in September, and then I'll review our fourth quarter operations performance.

When I joined OfficeMax, I immediately began analyzing and understanding our Contract, Retail, supply chain and merchandising operations. I spent significant time meeting with our employees, our management team, our customers and vendor business partners to identify our opportunities and challenges.

I was pleased to see the passion that our employees bring to the OfficeMax organization every day. This passion has contributed to material operating improvement in the past two years, and we share the belief that there are still many opportunity areas.

I'm impressed by the calibre of the individuals that make up our business segment and look forward to our collaboration in managing our operations as one company.

Now turning to our fourth quarter performance, in our Contract segment we adhered to our more disciplined new account strategy and created efficiencies from continuing our reorganization while putting programs in place for expanding profitability in the future. We experienced declining sales and our gross margin rates declined, but we achieved strong expense improvement resulting in operating income margin expansion to 4.4% from 4.3% in the fourth quarter of 2006 on an adjusted basis.

Now some details of Contract segment quarter four performance.

U.S. Contract, which represented about 70% of total Contract sales experienced a 7.8% decrease in sales versus the fourth quarter of 2006, and during the fourth quarter of 2007, December year-over-year sales declined at a higher rate than the rest of the quarter.

The Q4 U.S. Contract sales performance reflects several factors. First, we estimate about half of the decline in U.S. Contract sales in Q4 was due to lower sales by accounts that were in place in the year-ago period, reflecting softer business spending in the U.S.

Second, we continued to take a more disciplined approach to adding and retaining accounts. We reduced sales from new customers in Q4, focusing our efforts or higher-margin potential accounts, including the middle market. With gross margin rates 500 to 1,000 basis points higher than a typical large account, the middle market is a target for OfficeMax, but remains a relatively smaller share of our total U.S. Contract sales.

Third, we experienced lower small market sales, which includes our e-commerce public web site and catalog business versus last year. In the small market we reduced marketing investment which reduced sales but improved profitability, and we generated lower e-commerce sales during the re-launch of our public web site.

And fourth, as many of you know, during 2007 we terminated a significantly large unprofitable U.S. Contract account, which had started with OfficeMax in December of 2006. Exiting this account had a slightly negative impact on Q4 2007 sales, and we will continue to cycle the impact through the third quarter of 2008.

Contract gross margin in the fourth quarter of 2007 declined from last year to 21.7%, mostly due to lower vendor income and de-leveraging of fixed delivery costs. In the fourth quarter of 2007, we reduced delivery cost dollars versus last year, but delivery costs were slightly higher as a percent of sales. While Contract gross margins decreased in Q4 versus last year, we are pleased with the initial progress made in the second half of 2007, improving negotiated build gross margin from existing and new customers.

For existing large customers, our centralized pricing team is in place and pursuing win-win tactics, including negotiating increased private label sales and improved cost-to-serve offerings. For new and renewing customers, we are using centralized pricing controls and better analytics to drive improvement in account margin performance.

Looking sequentially at the fourth quarter compared to the third quarter of 2007, sales from new accounts decreased by about 8%, so we improved new account gross margin rates by about 80 basis points.

Contract operating expense as a percent of sales in the fourth quarter of 2007 improved from last year to 17.3%, and U.S. Contract operating expense was reduced due to targeted cost savings, including payroll and marketing cost reductions as well as lower incentive compensation. We also generated Contract expense leverage from international Contract operation sales growth.

Moving to our Retail segment, in the fourth quarter of 2007 we executed our store opening program and focused on promotional strategies to pursue profitable sales. We improved gross margin rates, but experienced higher expenses as a percent of sales due to reduced leverage on lower sales resulting in operating income margin declining slightly to 3.8% compared to 3.9% in the fourth quarter of 2006.

Now some details of Retail segment Q4 performance. Our same-store sales decreased 7.3% in the fourth quarter, reflecting a weaker spending environment by both consumers and small businesses. Similar to the Contract segment, Retail experienced its most challenging fourth quarter sales trends in the month of December. Higher ticket durable goods, furniture and technology categories were the most negatively impacted in Q4. About half the comp decline in Q4 is attributable to the international - pardon me, the intentional elimination of specific promotional activities from the prior year, with the remainder due to the overall weak Retail environment.

Based on independent third-party data, a softening U.S. economy impacted the overall Retail sector, particularly in many of the core electronics categories that would otherwise have been expected to sell well during the Q4 holiday period.

We concluded going into the fourth quarter that our prior year levels of Retail promotional investment would not be productive given anticipated soft consumer spending, and we took a more targeted approach. We eliminated underperforming promotional events early in Q4 and reduced the number of stores that participated in the Black Friday day after Thanksgiving event. And we continued lower weekly promotional investment through December, with about 11% fewer circular pre-print pages than last year.

Our strategy in the fourth quarter was to maximize our return from promotional spend given the weaker economy, which reduced sales but improved gross margins.

In the fourth quarter of 2007 versus the prior year, we experienced sales declines across all our major categories with the exception of ImPress, our print and document services. In the technology category, which represented 54% of Q4 Retail sales, we experienced declines in business machines, digital photography, peripherals and monitors.

In the fourth quarter of 2007, the technology sales growth we experienced earlier in the year reversed, with weaker consumer spending and as tech categories are most sensitive to our reduced promotional activity.

Our furniture category, which represented 9% of Q4 Retail sales, experienced our weakest same-store sales, reflecting slower consumer and small business spending. Our supplies and paper category, which includes ImPress, represented about 37% of Q4 Retail sales.

Supply sales were impacted by the lower consumer customer traffic counts experienced in our stores during the quarter.

OfficeMax ImPress produced low single-digit same-store sales growth for Q4.

Retail segment gross margin in the fourth quarter of 2007 increased from last year to 30.0%, primarily due to our more targeted promotional strategies that grow a sales mix shift, partially offset by a higher occupancy cost from our new stores. The mix shift was to a higher percentage of supplies category sales at higher gross margin rates and a lower percentage of technology category sales, which typically carry lower gross margin rates.

Retail segment operating expense as a percent of sales increased from last year due primarily to de-leveraging from new stores and the same-store sales decrease, partially offset by lower incentive compensation.

In the fourth quarter of 2007, we had a large number of new store openings  41 in the U.S. - which incurred pre-opening expenses and operating costs without generating significant sales.

Next I'd like to take a moment to outline some of the 2008 initiatives we are pursuing.

We entered 2008 after experiencing lower sales trends during December in both Contract and Retail, and our January and early February 2008 sales are tracking consistent with December. So our 2008 initiatives will reflect caution from a sales standpoint.

For our Contract segment in 2008, we expect to benefit from the progress we've made with our U.S. Contract reorganization to date, as well as from initiatives targeting profitable sales and from improved customer delivery and merchandise offering. We expect to maintain our disciplined approach to ramping up new, large middle and small customers, and we expect that U.S. Contract sales will also reflect the impact of weaker overall business spending.

On the delivery side in 2008, we plan to continue to refine our cost to serve with solutions for customers incorporating flexibility for delivery frequency and minimum order sizes.

Finally, we are planning to continue rationalizing our U.S. Contract product offering with more emphasis on meeting customer requirements for product selection, increased private label sales, and improving our stocking strategies.

For our Retail segment in 2008, while we remain cautious on the sales growth given the weaker economy, we expect to continue to adjust and target our promotional activities accordingly. We also expect to pursue cost containment.

We recently made important leadership changes in Retail management, with territory Senior Vice Presidents now reporting directly to me, and new leadership for store operations. As we evolve our Retail leadership structure, we are pursuing store cost efficiencies and improvements in our store selling culture, attachment rates and productivity.

Our 2008 Retail initiatives also include some significant new merchandising programs driven by target customer marketing identification completed in 2007.

In 2008, we also are focusing on initiatives that have an impact across our operating segments. We plan to further leverage our complementary business models for incremental sales from customers that can shop at Contract and Retail. An example is our Retail Connect program, which allows our Contract customers to enjoy their account pricing at our stores. In 2007 we grew Retail Connect cards by 33%. We are planning incremental sales in 2008 from Retail Connect and other cross-channel marketing programs.

As we pursue our one supply chain strategy, we also expect to expand our Retail store replenishment that utilizes our Contract facilities and to consolidate inventory management systems for improved planning across operations.

In merchandising, we plan to continue to rationalize our product offerings at both Contract and Retail for branded and private label merchandise. We view private label sourcing as a significant opportunity in 2008 and beyond.

Private label sales in the fourth quarter represented about 20% of Retail sales, 30% of Contract sales, and 23% in total, up from 21% in total for the fourth quarter of 2006. And we have the ability to further penetrate many key categories, especially through increased foreign direct sourcing.

Finally, we see opportunities for growth in efficiencies across our segments from our ImPress print and document services. We organized ImPress management  pardon me - we reorganized ImPress management during the fourth quarter of 2007 to better align its merchandising, store operations and sales force with the rest of our company. We expect this new ImPress alignment will enable improved productivity from store offerings as well as spur growth within our U.S. Contract accounts.

Overall, we're excited about our opportunity - operating plans for 2008. At this point, I'd like to turn the call over to Don Civgin so he can review financial details for the fourth quarter and full year 2007.

Don Civgin - Chief Financial Officer

Thank you, Sam, and good morning everyone.

Let's start with the P&L. For the fourth quarter of 2007, on a GAAP basis net income was $71.5 million or $0.92 per diluted share compared with net income of $58 million or $0.76 per diluted share for the same period last year.

For the full year 2007 on a GAAP basis, OfficeMax reported net income of $207.4 million or $2.66 per diluted share compared to $91.7 million or $1.19 per diluted share in 2006.

Results for the fourth quarter and full year 2007 and 6 include items which are not expected to be ongoing. Financial measures designated as adjusted are non-GAAP financial measures that exclude the impact of special items. We provide a detailed description of these special items, along with a reconciliation to GAAP financial results, in our press release today.

For the fourth quarter of 2007 as adjusted, net income was $51.1 million or $0.65 per diluted share, an increase of 37.4% from the same period last year. For the full year 2007 as adjusted, net income was $188.1 million or $2.41 per diluted share, an increase of 18.3% from 2006.

Consolidated net sales in the fourth quarter of 2007 decreased 2.6% to $2.2 billion from $2.26 billion in the fourth quarter of 2006.

Contract segment sales in the fourth quarter of 2007 decreased 0.8% to $1.17 billion compared to the fourth quarter of 2006, reflecting a 7.8% sales decline in U.S. Contract and a 20.4% sales increase from international Contract operations. In local currencies, international Contract sales increased 3.4% in the fourth quarter.

Retail segment sales decreased 4.5% in the fourth quarter to $1.03 billion compared to the fourth quarter of 2006.

For the full year, consolidated net sales increased 1.3% to $9.08 billion, reflecting Contract segment sales increase of 2.2% and Retail segment sales increase of 0.3% compared to 2006.

Gross margin in the fourth quarter of 2007 was 25.6%, flat compared to last year, reflecting lower Contract segment gross margin and higher Retail segment gross margin. Contract segment gross margin for the fourth quarter was 21.7%, down 80 basis points, and Retail segment gross margin for the fourth quarter was 30.0%, up 90 basis points from the same period last year.

For the full year 2007, OfficeMax gross margin was 25.4%, down 40 basis points from 2006, reflecting a decline in Contract segment gross margin to 21.8% and an increase in Retail segment gross margin to 29.5%.

Operating expense as adjusted for the fourth quarter of 2007 improved to 21.6% of sales, down 70 basis points from the same period last year, reflecting lower Contract segment operating expense, higher Retail segment operating expense, and lower corporate and other segment expense.

Contract segment operating expense for the fourth quarter improved to 17.3%, down 90 basis points compared to last year as adjusted. Retail segment operating expense in the fourth quarter increased to 26.2% of sales, up 110 basis points compared to the same period last year.

Our corporate and other segment expense for the fourth quarter of 2007 decreased by $13.8 million to $3.2 million compared to adjusted operating expense of $17 million in the same period last year. Corporate and other segment expense benefited in Q4 from a combination of lower incentive compensation and lower legacy company expenses along with a variety of targeted cost savings compared to the same period last year. The corporate and other expense reported in the fourth quarter was lower than we would expect on a run rate basis going forward.

For the full year 2007, OfficeMax operating expense improved to 21.6% of sales, down 70 basis points from 2006 as adjusted, reflecting Contract segment operating expense improvement to 17.5% of sales, Retail segment operating income - operating expense increased to 25.4% of sales, and corporate and other segment operating expense improvement to $37.4 million.

During the fourth quarter of 2007, OfficeMax recognized other income of $32.5 million related to our additional consideration agreement that we entered into in connection with the October 2004 sales of our paper, forest products and timberland assets.

Our effective tax rate on a GAAP basis for the fourth quarter of 2007 decreased to 35.4% from 41.5% last year, and for full year 2007 decreased to 37.1% from 40% in 2006. The fourth quarter and full year 2007 effective tax rates benefited from the resolution of certain tax matters.

Moving to the balance sheet, we ended 2007 with inventory $16.8 million higher than at the end of the third, primarily due to store growth and an increase in international Contract inventory due to foreign currency exchange rates, partially offset by lower inventory per store. Inventory per store decreased approximately 4% at the end 2007 compared to the end of 2006, benefiting from supply chain and inventory management initiatives. And at the end of 2007, our Retail clearance and discontinued inventory level was at the lowest in four years.

Inventory turns decreased to 6.4 in 2007 from 6.7 turns in 2006, primarily due to lower turns from new stores as they ramp up sales productivity.

Accounts payable ended 2007 $136.4 million lower than 2006, primarily reflecting the timing of vendor payments, including fourth quarter 2007 holiday and first quarter 2008 Back-to-Basics inventory purchases.

We ended 2007 with accounts receivable $158.4 million higher than last year was, primarily as a result of terminating our accounts receivable securitization program on July 12, 2007 with the simultaneous restructuring of our revolving credit facility.

By amending and restating our revolver, we expect improved financing terms and lower total costs. At the end of 2007 under our amended $700 million revolver, we had $614.5 million available, reflecting no borrowings and $85.5 million of letters of credit issued under the revolver.

At the end of 2007, we had total debt, excluding the timber securitization notes, of $398.4 million and cash and cash equivalents of $152.6 million. We calculate total debt excluding the $1.47 billion of timber securitization notes since recourse on the notes is limited to the $1.635 billion of timber installment notes receivable.

Turning the cash flow, during the fourth quarter of 2007 we generated $39.2 million of cash from operations, an increase of $3.3 million from the fourth quarter of 2006. For the full year 2007, we generated $70.6 million of cash from operations, a decrease of $305.1 million from full year 2006, primarily due to increased accounts receivable and lower accounts payable.

Capital expenditures totalled $39.5 million for the fourth quarter of 2007 and totalled $140.8 million for 2007. The largest components of capital expenditures in 2007 were related to new stores, other store capital projects and information technology.

I'll now turn the call back to Sam Duncan.

Sam Duncan - Chairman and CEO

Thanks, Don.

Overall, while we have work ahead of us, we made substantial progress on our turnaround during 2007. The action plans we implemented at both Contract and Retail as well as the improvements we have made to our supply chain and IT structure have strengthened OfficeMax and we believe positioned the company for long-term shareholder value creation.

With the progress we made in 2007, our sights are now set on 2008. We anticipate continuing to operate in a challenging consumer and business spending environment. With early 2008 sales continuing to experience year-over-year declines, we expect to pursue margin and cost management initiatives throughout 2008.

We plan to provide additional details of our 2008 outlook and the initiatives that will drive our performance at our OfficeMax investor day planned for March 19.

Before turning the call over for questions, we'd like to acknowledge our OfficeMax associates for their commitment and dedication to servicing our customers and pursing the initiatives that we believe will lead to increased shareholder value.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Mitch Kaisser of Piper Jaffray.

Mitch Kaisser - Piper Jaffray

Good morning, guys. I was curious, first of all, on the - you mentioned continued sales pressure in January and February, but you did a very good job of managing Retail margins in the fourth quarter. Is it fair to assume, then, that the gross margin rate is comparable to the fourth quarter? You still seeing pretty decent lift from gross margin?

Sam Duncan - Chairman and CEO

Mitch, first, this is Sam Duncan, and I'll make some quick comments and then turn it over to Sam Martin.

We feel good about the path that we're on with the current economic environment, and still seeing headwinds ahead of us. And so we're going to continue to focus on the margins for both the Retail and Contract and expenses.

Now I'll let Sam make some comments.

Sam Martin - COO

Yeah, Mitch, our expenses in January and February will mirror our levels from the end of Q4, as will our margin. So we don't expect a huge departure from what we saw at the end of Q4 as we see January and February at this point.

Mitch Kaisser - Piper Jaffray

Okay. Obviously you made really nice headway on the corporate overhead. I think that's going to be much lower than people were expecting, and you said that that would not be a normalized run rate. Would you give us a sense for what that might be, maybe not on a quarterly basis, but what's a number that we could work from on an annual basis?

Don Civgin - Chief Financial Officer

Hey, Mitch, it's Don. Yeah, I mean, I think in the fourth quarter the number was abnormally low from a run rate point of view due to some of the things we talked about. I mean, the corporate incentive plans, some legacy costs and reserves which came in favorable, and some reduction in some of the unallocated corporate expenses.

So going forward I would expect the number to be, frankly, probably more consistent with what it's been like the rest of 2007.

Mitch Kaisser - Piper Jaffray

Okay.

Don Civgin - Chief Financial Officer

Does that answer the question?

Mitch Kaisser - Piper Jaffray

Yeah, that does answer the question. Thank you. And I don't know if you saw the news this morning. Obviously, Staples is making a run at Corporate Express. Is there any thoughts behind that?

Sam Duncan - Chairman and CEO

Well, I - this is Sam Duncan. Our company - myself and our company - we have a great amount of respect for Ron Sargent and his team at Staples, as we do at Corporate Express. But other than that, it wouldn't be appropriate for us to make any comments on that.

Mitch Kaisser - Piper Jaffray

Okay. Thanks, guys. Good luck.

Sam Duncan - Chairman and CEO

Thank you.

Operator

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

Matt Fassler - Goldman, Sachs & Co.

Thanks a lot, and good morning to you.

Sam Duncan - Chairman and CEO

Good morning.

Matt Fassler - Goldman, Sachs & Co.

I'd like to first focus on the question of incentive compensation and just the whole notion of reserve reversals in the quarter. You know, you spoke about the vis-à-vis bonuses, maybe some legacy cost accruals. I'm not sure if there were reversals there as well. And I know it showed up probably most distinctly in corporate G&A, but perhaps it was - I think it was mentioned in at least one other expense line item. So if you could try to quantify the degree to which that aided the bottom line and maybe talk about, you know, in which quarters you might have over reserved, because obviously your earnings would have been depressed earlier in the year from -

Don Civgin - Chief Financial Officer

Yeah, Matt, it's Don. First of all, I think it's an ordinary process to go through all the accruals and the reserves at the end of each quarter, so I wouldn't suggest that we had over or underdone anything in previous quarters. I think they were appropriate in the quarter in which they were made.

Matt Fassler - Goldman, Sachs & Co.

Of course.

Don Civgin - Chief Financial Officer

With respect to the corporate incentive numbers, they were reduced in 2007 in the fourth quarter primarily because of performance, and it was pretty substantial. So, I mean, the number, if you look on a year-over-year basis, was approximately $15 million lower than last year, and it was spread between Retail, Contract and corporate.

Matt Fassler - Goldman, Sachs & Co.

And that would have been in the fourth quarter or for the year in the aggregate?

Don Civgin - Chief Financial Officer

That's for the fourth quarter 2007.

Matt Fassler - Goldman, Sachs & Co.

$15 million? Got you. Okay.

Secondly, on the payables front, you spoke about the timing of vendor dollars payments, et cetera, you know, with relation to holiday and a couple of quarter-specific issues.

That being said, I know that that's a number that's been down year to year for most of this year, and if you could give us some sense as to A) you know, at what point you think the payables ratio, you know, sort of finds some stability, and B) whether there's any relationship between the gross margin [inaudible] capture and the terms that you get vis-à-vis vendors.

Don Civgin - Chief Financial Officer

Sure. I mean, look, the relationship with the vendors is pretty complicated, so there's a lot of factors that go into it. One of them is the payables terms, so it's really hard to look at that in isolation.

But you're correct; the trend this year has been lower all year long than what it was in 2006, and I think while it is lower, I don't know that we're going to recover any of that next year. I think it's lower for some, you know, substantially good reasons, and we will always work to make that number work in our favor, as will everybody else. But I don't ever want to do that at the cost of damaging our relationship or having pushback in some other part of that relationship with the vendors.

So it is lower. It did cost us some cash flow this year, and we'll work to make that as attractive as possible going forward, but I wouldn't expect it to go back to 2006 levels.

Matt Fassler - Goldman, Sachs & Co.

Understood. And then just one final question. You know, it looks like you backed off some of the lower margin businesses, particularly in technology on the Retail front, and obviously continuously with lower margin Contract customers. But focusing for a moment on Retail, to the extent that you choose to maintain the promotional discipline that we saw this quarter, are there a couple quarters left where you could cycle more aggressive stance scenarios like technology and have sort of a similar sales and margin trade off that we saw this past quarter?

Sam Duncan - Chairman and CEO

This is Sam Duncan. I'll just make a quick comment and let Sam Martin make a remark.

What's going to play - the biggest factor is still going to be the economy, and what we are seeing is a pretty dramatic drop off of purchase of high-ticket goods  printers, faxes, computers, those type of things. And that is going to continue because people will put off purchasing that.

Our two biggest holiday time periods is, of course, the Christmas holidays and then Back-to-Basics - what we call Back-to-Basics, which is in the first part of the year. We don't see or I don't recall any big promotions that we're going to be coming up against the remainder of the year until we get to the holidays that I can think of, but I'll let Sam Martin make a comment on that.

Sam Martin - COO

Yeah, the only - Matt, the only - this is Sam Martin - the only real initiative from a year ago that we will be up against is really the launch of new technology that occurred in the first quarter last year. We are cycling that currently, and that is in what we spoke about our trends currently in January and February.

But to your other point about our promotional activity focusing on other categories than technology, we have initiatives to continue to focus on those promotional activities and categories that give us the best return, and so there will be a continued into the first half of '08 and perhaps beyond initiatives that will indeed keep us focused on those that give us the best return.

Matt Fassler - Goldman, Sachs & Co.

Got you. Guys, thank you so much.

Operator

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

Brian Nagel - UBS

Hi. Good morning.

Sam Duncan - Chairman and CEO

Good morning.

Brian Nagel - UBS

I guess I just want to follow on one of the previous questions. Just in the terms of the Retail business, if we can get some more color in what you're seeing there and the trend. We've seen some weakening in sales, but is there a geographical component to it?

And then I guess you mentioned in the previous question or in answer to the previous question that you've seen pronounced weakness in more of the bigger-ticket purchases, but is that also spilling over to, you know, are people being more careful on the purchase of supplies as well?

Sam Martin - COO

Thanks, Brian. This is Sam Martin again. From a geographical standpoint - and I'll talk about that first - we really don't see a significant impact differently by geography. We have a few areas of the country that seem to be a little stronger than others, but there's no significant amount of difference to speak to today.

And with regard to the - oh, boy, I lost my - supplies, yeah. The only impact that we feel is a little bit of lack of foot traffic, which then passes across the entire store, supplies, et cetera. But most of the real headwind is coming from the higher-ticket areas, as Sam Duncan mentioned earlier, both technology and furniture.

Brian Nagel - UBS

As you look at your customer data, can you tell if that is more your core small business customers? Is it more Retail-type traffic that's slowing the purchasing patterns?

Sam Martin - COO

Our data really doesn't show us a differentiation between the two. Both small business and Retail consumer foot traffic are impacted similarly in our data.

Brian Nagel - UBS

Okay. And the second question I have, with the outlook now, as you expect this sales weakness to persist, does that cause you to re-think your store opening plans for either this year or even over the longer term?

Sam Duncan - Chairman and CEO

We feel good about the store plans that we talked about earlier - 40 new stores and 50 remodels. Of course, as the year goes along, you know, if the economic environment changes for the worse, then us, like anybody else, would have to analyze that and make sure that, you know, we're still doing it.

But when it comes to new stores, one thing you've got to remember, Brian, is that, you know, we made these acquisitions of these leases a year or two ago, so consequently most of those you just can't shut down, whereas remodels you can make a quick change and either stop them or put them off.

But we feel good about what we've got planned, especially with the plans that we put in place in the last half of the year when we took those 12 beta stores and worked with them to make sure that we value engineered and got, you know, all the timing issues together and everything. So we feel good about our remodel process that we'll be implementing this year.

Brian Nagel - UBS

Okay, thanks a lot and good luck in the next quarters.

Sam Duncan - Chairman and CEO

Thank you.

Operator

Your next question comes from the line of Seth Basham of Credit Suisse.

Seth Basham - Credit Suisse

Good morning, gentlemen, and congrats on a great quarter.

Sam Duncan - Chairman and CEO

Good morning.

Seth Basham - Credit Suisse

A couple questions for you. The first one would be regarding vendor income. You mentioned that as a drag on gross margins in the Contract segment. How did it impact you on the Retail side?

Sam Duncan - Chairman and CEO

Well, on the Retail side, it's a simple rule of thumb. As sales go down, your purchases go down, which your vendor income goes down. And that's just really how it works, Seth. There's nothing else that, you know, changes.

Also, if you run less promotions, which causes your sales to be down and your purchases to go down, of course, that's going to be affected. But it's everything is all - it works in unison, so it's a simple factor of sales.

Seth Basham - Credit Suisse

Okay. I'm sorry. Could you give us a little bit more detail, then, on the year-over-year change in gross margins on the Retail side? How much did vendor income cost you the margin and then how much do you benefit from lower promotions and mix?

Sam Martin - COO

Yeah, Seth, this is Sam Martin. I don't have the exact numbers, but I can tell you that the mix change to supplies, et cetera, from tech and furniture and our promotional activities was certainly an offset, as well as an increase in our private label investments in terms of the rise in sales in those categories impacted by our direct foreign sourcing gave us some advantages in margin, the combination of which did offset the lack of vendor income in the Retail side.

Don Civgin - Chief Financial Officer

And Seth, just to be clear, I mean, the vendor income impacted Contract more than it did Retail, so there was much less to offset when Sam talks about the mix shift in Retail helping us. There was a much smaller number to offset in Retail.

Seth Basham - Credit Suisse

Okay, fair enough. And then secondly, on the Retail side, clearly a very good quarter from an expense perspective. Now going forward, do you have as many opportunities to reduce expenses?

Sam Duncan - Chairman and CEO

This is Sam Duncan. We see opportunities, Seth, that we're going to put some plans in place to take advantage of those this year. And I'll let Sam Martin make some comments.

Sam Martin - COO

Yeah. Again, Seth, much of our initiatives in the back half of the year of 2007 and particularly in the fourth quarter on expense reductions carry forward into the first part of 2008. And we do have targeted expense reductions to go further as we get into the year from a duplication standpoint and other expenses that we can have targeted as initiatives to reduce.

Seth Basham - Credit Suisse

Okay, great. And then just lastly, maybe if you could roll it all together here, talking about a lot of great margin things happening, at least through the early part of 2008, would that suggest that you expect operating margins to be up for the company for the year?

Sam Duncan - Chairman and CEO

Seth, the only thing I'll say is when I came to this company back in April of '05, when you look at the delta between us and the best in class in our business, which is Staples, the gap between us and Staples was some 400 basis points in margin and our expenses were 240 basis points higher, so that's what we're constantly working on in everything that we do in our company.

Seth Basham - Credit Suisse

Great. Thanks a lot, guys, and we'll see you in March.

Sam Duncan - Chairman and CEO

Thank you.

Operator

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

Chris Horvers - Bear Stearns

Thanks, and good morning. A follow up on the vendor allowance question - did that also include a reversal in 4Q from prior accruals? Obviously, as you mentioned on the incentive comp side, the right estimates went into it earlier in the year, but was there a reversal as well and how much was that?

Don Civgin - Chief Financial Officer

It was about - Chris, it's Don - it was a fairly small number.

Chris Horvers - Bear Stearns

It was a small number, okay.

Don Civgin - Chief Financial Officer

Yeah, I mean, John can get back to you with the details, but it was not a very large number.

Chris Horvers - Bear Stearns

Okay. And then with respect to the remodel program, can you talk a little bit about the plan cost and what your sales and margin targets are in executing these remodels?

Sam Duncan - Chairman and CEO

Chris, we haven't talked about that information before, and we may talk about that at the investor day conference in March, but we haven't discussed that in the past.

Chris Horvers - Bear Stearns

Got you. And then the last question, clearly no comment on Staples and the Corporate Express. Could you maybe frame out how much market share that each of them controls in the U.S. Contract side versus the market share that you control?

Sam Duncan - Chairman and CEO

I don't know. We couldn't answer that at this point. We'd have to look at some research. You probably have better information than what we do.

Chris Horvers - Bear Stearns

Okay. Thanks very much.

Sam Duncan - Chairman and CEO

Thank you.

Operator

Your next question comes from the line of Oliver Wintermanel of Morgan Stanley.

Oliver Wintermanel - Morgan Stanley

Yeah, good morning. I have two questions.

In the Contract gross margin where it impacted by higher paper prices in the third quarter, did you continue to see that in the fourth quarter?

Sam Martin - COO

Oliver, Sam Martin here. Yeah, our paper price increases, we did continue to see, and our initiatives to negotiate those through to our customer have started to take effect. So as we get impacted on paper cost increases, we are working with our customers to pass as much of that along as possible in our negotiations.

Oliver Wintermanel - Morgan Stanley

And the second question was over the last few quarters you've said you would target more the small and medium market customers. Can you give us a little bit more color on how this is progressing?

Sam Martin - COO

Well, like we've said, that is an opportunity for us. We have about 13% of our Contract business in that arena today, so as we look at small and middle market customers, that is our largest opportunity for growth.

And our intention is not to only grow that from year-over-year sales within our current customer base but really to seek out and we have strategies in place to actually put more hunting resources against those small and medium-sized businesses.

Oliver Wintermanel - Morgan Stanley

Great. Thank you.

Operator

Your next question comes from the line of [Chris Blanton] of [Russell and Hazel].

Chris Blanton - Russell and Hazel

Hi, Sam. This is Chris Blanton with Russell and Hazel. I just wanted to follow up on a comment that you had regarding trend to increase your traffic to the stores. Can you tell us what you're doing with that Eve - All About Eve - initiative?

Sam Duncan - Chairman and CEO

Well, that's actually something that we haven't discussed publicly, and we will discuss at our March conference, so I really don't want to go into detail on that.

Our company, like any other company, is always looking at how to merchandise a store to drive more traffic, and that's what we're doing with our Advantage format. If you look at our stores, the majority of our stores have never been touched in the remodels and still have the old warehouse, high-rack look. And our goal is to get the stores to open up, lower profile, and so it's visible with more calmer colors - the yellows, greens and tans - and we're very happy with where the Advantage format is.

But we'll talk about more specific merchandising details at our investor conference in March.

Operator

Your next question comes from the line of Steve Chick of J.P. Morgan.

Steve Chick – J.P. Morgan

Hi, thanks. I guess, Don, I was wondering, in your comments about December sales and how the sales ended in the quarter for both Retail and Contract, and how they started in both January and February, can you give us a little more granularity on kind of where sales exited for the two segments, you know, in terms of comps and the U.S. Contract business. And so, you know, what type of levels are we looking at right now for the first two months of the year?

Sam Duncan - Chairman and CEO

This is Sam Duncan, and I'll make some comments first.

You know, we continue to see headwinds in the business world. You know, our comps in the second half of the quarter were, you know, not very good. Actually in the month of December, it did seem business dropped off the side of a table, I guess you could say, and it just came to a stop.

As we've talked about, where we see it is in the high-ticket items. We continue to see that. We've seen many reports of possibly the economy improving in the third quarter. I don't know if that's going to happen or not.

Our intention is that we're going to hunker down in this company, and we're going to focus on reducing our costs until we can, you know, get through this transition that we're going through, the bad economy.

And that's our focus, and we're going to proceed as though it's not going to get any better than what we've seen in the past couple of months.

Steve Chick - J.P. Morgan

Okay, that's fair. I guess I was just wondering how, you know, just so we have our forecast down correctly if, you know, we're talking about kind of comps for sales down currently double digits and if we're talking about U.S. Contract, you know, which was down I think 7.8 for the quarter, if we're thinking, you know, that being down double digits currently as well. That's kind of what I'm looking for.

Sam Duncan - Chairman and CEO

I don't want to go into specifics. We just said, you know, December was worse than our overall quarter trends, and we'll just stick with that, Steve. And we might give more details in March. I'm not sure.

Steve Chick - J.P. Morgan

Okay, and then second question related to the lower vendor income in the fourth quarter, you know, in Contract, does that have a more dramatic weighting typically on the fourth quarter for the Contract business or - and so if volumes are decelerating further going into the first half of this year, is this something that we can plan on, you know, weighing on Contract gross margins further going into, I guess, the first half of '08, so to speak.

Don Civgin - Chief Financial Officer

Yeah, Steve, it's Don. I mean, there's a lot of things that factor into vendor income levels. One of them is purchases. The other one that impacted us in the fourth quarter, frankly, was that we were not able to repeat some of the programs we had in the fourth quarter of last year.

So I don't think typically there would be that sort of seasonality, and it is driven by volume, but I think the fourth quarter was particularly dramatic in Contract.

Steve Chick - J.P. Morgan

Okay, because your Contract gross margins, just given what you've been doing with low-profit accounts, was a little bit surprising to me, the Contraction there. So as we look into '08, you know, can we start to think about, you know  I mean, because you guys were making some sequential improvements in '07 up until now. Do you think you'll get back onto the sequential improvement phase again as we go into this year?

Don Civgin - Chief Financial Officer

Steve, what I'd say is I think we're all very proud of the sequential improvements we've been making this year because of the hard work that the team has done with the Contracts we have and the new acquisitions. That's continuing.

But what happens is the combination of those two factors that impacted vendor income and then the revenue decrease de-levers our fixed costs for delivery. So it just makes it more difficult in a lower-revenue environment to maintain the improvements in margins that you were seeing earlier in the quarters.

Steve Chick - J.P. Morgan

I guess given the comparisons in '08, the 80 basis points down for this fourth quarter, I would hope that would be a low in terms of the deterioration you might see into next year, even with down volumes. Can I think about it that way?

Don Civgin - Chief Financial Officer

I guess what I would say is this: We're going to get together next month and share with you some more details about where we think we're headed, and I really don't want to get into too many specifics before that call.

Steve Chick - J.P. Morgan

Okay. All right, that's fair. And then last, if I could, you know, your operating cash flow, I guess, was helped, you know, by the net $20 million this quarter. You know, without it operating cash would have been down year-over-year, I think. What is your 2008 Capex budget at this point, and do you expect to be free cash flow positive in '08?

Don Civgin - Chief Financial Officer

You know, let's talk about that next month as well. I think the answer is absent a few items like the payables leverage and the repayment of the accounts receivable securitization, our cash flow this year was actually reasonably good.

And listen, we've said for years - for the last two years - that that's a very, very important metric for us, and we'll continue to focus on it in 2008.

But the benefit of where we are right now with this refinancing that we completed in 2007 is we've got a lot of cash available to us. I wouldn't expect that we'll see the kinds of payables deterioration we saw this year again. And so I think we feel like we're going to have a strong 2008 from a cash flow point of view.

Steve Chick - J.P. Morgan

Okay, thanks. I know I said that was the last one, but one more. Just Don, the $15 million number that you had thrown out for, I think, the lower year-over-year incentive compensation figure - I think that was the number you threw out there  how much of that was a reversal versus the number being just simply down year-over-year? Did you say that?

Don Civgin - Chief Financial Officer

Well, I think you're asking two separate questions. The $15 million represents the lower amount of incentive expense we have this year versus last year. So some of that obviously would be a reversal from what we were accruing at the end of the year.

Steve Chick - J.P. Morgan

Did you say what piece of that was the reversal?

Don Civgin - Chief Financial Officer

I would say from trend that would probably be the majority of it.

Steve Chick - J.P. Morgan

Okay. All right, that's helpful. Thank you.

Don Civgin - Chief Financial Officer

Sure.

Sam Duncan - Chairman and CEO

Thank you.

Operator

There are no further questions at this time. Gentlemen, do you have any closing remarks?

Sam Duncan - Chairman and CEO

We'd like to thank everybody for attending this morning. Thank you very much. Have a great day.

Operator

This does conclude today's conference call. You may now disconnect.

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