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Staples, Inc. (NASDAQ:SPLS)

Q4 2007 Earnings Call

March 4, 2008, 8:00 am ET

Executives

Laurel Lefebvre - Vice President of Investor Relations

Ron Sargent - Chairman and Chief Executive Officer

Mike Miles - President and Chief Operating Officer

John Mahoney - Vice Chairman and Chief Financial Officer

Demos Parneros - President of US Stores

Joe Doody - President of North American Delivery

Analysts

Oliver Wintermantel – Morgan Stanley

Danielle Fox – Merrill Lynch

Colin McGranahan – Bernstein

Matthew Fassler – Goldman Sachs

Dan Binder – Jefferies

Brian Nagel – UBS

Gary Balter – Credit Suisse

Anthony Chukumba – FTN Midwest

Chris Horvers – Bear Stearns

Jack Murphy – William Blair

Steve Chick – JP Morgan

Joe Feldman – Telsey Advisory Group

Operator

Good day ladies and gentlemen and welcome to the Fourth Quarter and Fiscal Year 2007 Staples, Inc. Earnings Conference Call. [Operator Instructions] I would now like to turn the presentation over to your host for today’s call Ms. Laurel Lefebvre, Vice President of Investor Relations.

Laurel Lefebvre

Good morning everyone and thanks for joining us for our Fourth Quarter and Fiscal 2007 Earnings Announcement. Unless otherwise indicated numbers discussed in today’s call exclude the impact of non-recurring items that occurred in Q3 of 2006 and Q3 2007. All comparable period measures exclude the 53rd week in fiscal ’06. We’ll also discuss some additional non-GAAP metrics such as return on net assets to provide useful information about our financial performance. Please see the financial measures and other data section of the investor information portion of www.Staples.com.

For reconciliation of GAAP to non-GAAP numbers and explanation of our financial measures. Certain information contained in this call constitutes forward looking statements for purposes of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by such forward looking statements as a result of various important factors including those discussed and referenced under the heading risk factors and elsewhere in Staples latest 10-K filed this morning.

Here to discuss Staples Q4 and Fiscal 2007 performance and business outlook are Ron Sargent, Chairman and Chief Executive Officer, Mike Miles, President and Chief Operating Officer and John Mahoney, Vice Chairman and Chief Financial Officer. Also joining us are Demos Parneros, President of US Stores and Joe Doody, President of North American Delivery.

Ron Sargent

Good morning everybody, I’m pleased to announce another quarter of solid sales and earnings growth for the company with strong sales performances from our North American Delivery and International businesses. North American Retail continued to operate in a tough environment that dampened the top line but our retail team did a great job managing expenses to maintain our strong margins.

Let’s first take a quick look at the headlines for both the quarter and for the full year. Excluding the impact of the extra week that we had in 2006 our Q4 top line grew 8% to $5.3 billion in 2007. Operating margin was up 20 basis points to 9.7% and operating income grew 11% to $517 million. Net income also increased 11% to $333 million and diluted earnings per share was up 15% to $0.47 per share. North American Retail had modest sales growth with slight operating de-leverage.

Our North American Delivery business sales growth slowed slightly during the quarter but it still grew a very strong 12% year over year. Our International business grew sales in local currency 8% while driving a big improvement in margin. For the year, excluding the extra week in 2006 total company sales were up 9% to $19.4 billion, net income increased 12% and earnings per share was up a strong 15%. Operating cash flow increased 18% over 2006 to $1.4 billion as working capital was helped by process improvements around vendor receivables and reductions in inventory per store.

After $470 million in capital expenditures we generated a record $891 million in free cash flow which was 43% increase over 2006. We returned $958 million in excess cash to shareholders through our annual cash dividend and share repurchase program. We delivered pretty good results in 2007 despite negative same store sales in our largest business segment. Even in the fourth quarter we did a good job of cost management in a very soft sales environment. We didn’t chase unprofitable sales and we continue to make investments to improve the business.

Our results for the year reflect a lot of hard work, attention to detail and a continued focus on customers. We got a lot done during the year and I’d like to highlight just a few accomplishments in each of our three business units. First, North American Retail, we opened 120 new stores including 11 stores in Denver which is our most recent new market entry. We launched our first three stand alone Copy & Print shops in Manhattan. We entered into an agreement to sell Dell computers, printers, ink and toner making Staples the exclusive supplier of Dell products in the office superstore channel.

We launched a major cross category initiative Security by Staples offering a large assortment of security related products and services. We continued to add to our Copy and Print center services including the roll out of business cards in minutes. Finally, we invested heavily in driving awareness and trial of our newest service offering Staples EasyTech and saw nice sales growth there.

We also had another great in North American Delivery. Our Delivery segment had strong mid-teens top line growth with each of businesses contract, quill and Staples Business Delivery achieving record sales. In Staples Business Delivery we upgraded our website and we saw increased customer traffic as a result. We continue to invest in our distribution network opening a new multi-channel fulfillment center in Denver and a smaller single channel facility in Nova Scotia to support our growth there. We are recognized by J.D. Power and Associates for outstanding customer service in the call centers of all three North American Delivery businesses.

We completed the integration of the [Chisweg] and Thrive acquisitions that we made in 2006 expanding our offering in mail and ship supplies and IT services. We acquired American Identity which got us into the $18 billion promotional products market and now sell logoed merchandise to contract customers. We also invested in Copy and Print services in North American Delivery. It’s another big opportunity we opened four closed door copy centers we now have seven of those operating around the country.

Turning to our International business we had a great year with operating profit more than doubling and the profit rate increasing by 154 basis points. Europe’s profit improvement was even better, up about 200 basis points. Good progress toward our 7.5% operating margin goal. Our European retail business improved advertising and direct mail effectiveness, consolidated purchasing, drove penetration and increased supply chain efficiency. In our European catalog business we improved our supply chain, increased customer satisfaction scores, improved perfect order metrics and drove higher we penetration.

We doubled sales in China reaching $200 million in annual revenue. The Delivery business in Beijing and Shanghai grew nicely and we expanded operations in the ShenZhen. We also launched retail operations in China and now have 32 stores there. In India our joint venture with Future Group got off to a great start. We now have contract operations in all major cities and we opened our initial retail locations in Bangalore through our joint venture.

Finally in terms of initiatives impact the whole company we’ve made great progress with our own brand in 2007. We introduced hundreds of new products including the M by Stapes line. We also made progress in consolidating own brand products and driving increased penetration in Europe. To manage this important piece of our business we recently gave the Staples Brand Group capabilities and accountabilities that are in line with other world class suppliers. Own brand penetration for the year was 22% and we remain committed to getting to 30% over the next few years.

While we are pleased with our many accomplishments during the year we are not as pleased with our sales in our North American Retail business. Despite the tough sales environment I feel that our North American Retail team did a great job in adapting to the environment and carefully managing expenses to drive bottom line results. At the same time we are very proud of our performance in our North American Delivery and strong bottom line improvement in our International business.

We believe we have the right long term strategy. We know from our experience in the last recession that if we can continue to invest in the business while still maintaining tight controls over expenses and capital expenditures we are going to emerge from the tough times in great shape and we’ll be able to extend our lead in the market place. Despite the challenges we faced in 2007 we maintained our initiatives and our investments in growth initiatives and we’ll do so again in 2008.

We’ll continue to invest in new stores, new markets, and customer services, own brand, Copy and Print centers, Staples EasyTech, Supply Chain, Information Systems and new product categories. Although the immediate economic environment still looks choppy we are in a solid position for continued good earnings growth. Before I turn the call over to Mike I’d like to take a moment to comment on our proposal to acquire Corporate Express.

We have great respect for Corporate Express’ business as well as the people and we believe that our proposal represent a full and fair price for the company. The proposed combination makes great strategic sense and will create significant value for stakeholders in both companies. In light of the current situation we feel that probably the less said the better and we don’t plan to address questions on the proposed acquisition in today’s conference call. I’ll now turn the call over to Mike to discuss our North American Retail and Delivery businesses in a little more detail.

Mike Miles

Good morning everyone. During the quarter North American Retail grew sales 3.5% adjusted for the extra week to $2.8 billion. Sales comps fell 6% driven by weaker customer traffic as average order remained relatively flat. Durables comped negative 8% and consumables comped negative 4%. We saw strength in computer, GPS, Staples EasyTech, Copy and Print and ink while furniture and business machines were weak and supplies turned negative after comping positively in Q3.

Sales were weaker than expected throughout the quarter but we had a particularly slow December. While there were a few hot selling items during the holiday season such as the Dell assortment, GPS and digital frames we saw a significant drop off in consumer spending that month. The trend improved somewhat in January as we returned to our core small business and home office customers but it remained negative.

Clearly managing costs was a priority during the quarter, we improved store labor processes allowing us to leverage payroll expenses and still drive better customer service metrics. We’ve had a number of wins with our process excellence program which has helped drive efficiencies and lower costs throughout our supply chain. Despite our cost management efforts the weak top line caused de-leverage of many of our fixed expenses particularly rent and depreciation. As a result Q4 operating margin adjusted for the extra week in 2006 declined 20 basis points to 10.6% and operating income increase by only 1.7% to $297 million.

While we are very conscious of the need for tight cost controls we are also committed even in these tough times to making investments to drive traffic and increase sales in our stores. Let me elaborate on some of the successful merchandising initiatives that Ron has just touched on. First, our arrangement to sell Dell computers is off to a great start. We’ve seen a steady ramp up in sales since the product launch as customers have shown strong interest. The combination of hardware, ink, peripherals and extended services plans makes Dell a winner for both sales and operating income.

We’ve just started to shift the focus of our advertising and promotion to ink and toner consumables and expect these higher margin skus to continue their strong sales ramp throughout 2008. As the only retailer offering a full line of Dell ink we have an opportunity to drive substantial new customer traffic. Sales in other brands have not seen a material negative impact due to the successful Dell launch and we have planned a number of marketing initiatives to drive continues sales of Dell and believe this product line will be a big win for us in 2008.

In Q3 we launched Security by Staples a cross category offering of data storage products, anti virus software, shredders and services. In 2008 we plan to significantly increase the marketing for this initiative with the goal of making Staples the preferred destination for information security solutions.

Turning to services the in store Copy and Print center continues to be one of our best performing categories. The strong results in this category reflect our attention to training, good marketing and new products such as business cards in minutes. In 2008 we plan to follow up on the success of business cards in minutes by launching customized letterhead and envelopes in minutes as well as expanding our offering of wide format signs and banners.

Our stand along Copy and Print shops continue to ramp up. We have found that these stores are a hit with small businesses and we have begun to deploy sales people to drive faster growth. In addition to the four stores we have in Canada we now have three open in Boston and three in Manhattan had will open several more in 2008. The other key service offering in our stores, Staples EasyTech continues to ramp well. We nearly doubled sales albeit on a small base as we continue to drive awareness for this service.

We had a number of exciting offers tied into the Dell launch that were particularly successful. Although we are dealing with a tough economy we are sticking with our steady measured new store opening plan. In 2007 we opened 120 stores, 100 in the US and 20 in Canada which brings our total to 1,738. Included among these 120 stores were 11 as part of our latest market entry into Denver as well as several fill in stores in the previous entries into Miami and Chicago. We are quite pleased with the results of these recent market entries and it gives us confidence in our ability to successfully enter the remaining 10 major markets where we do not currently have a presence.

Our four store formats Dover, urban, rural and Copy and Print shop allow us to pick the right format for the right location. In 2008 we plan to open approximately 100 stores including stand along Copy and Print shops. We can’t predict when the economic environment will turn around so we are focused on executing our strategy, working hard at the basics of merchandising and customer service. This will put us in a good position when the economy picks back up.

Turning now to North American Delivery in Q4 excluding the extra week sales grew 12.4% to $1.7 billion with organic sales growth of 8.2%. Sales grew through new customer acquisition as we invested in prospecting through our sales force and direct mail activities. Our investments in share of wallet categories like JanSan, Copy and Print, promotional products and mail and ship continued to pay off as these categories grew at multiples of the overall segment growth rate.

Despite the share of wallet success sales to our existing customer base slowed as reflected in moderating average order size. By customer segment sales to the middle market continued to do well especially in Staples Business Advantage and Staples Business Delivery. We continue to see rapid growth in online sales. In 2007 worldwide e-commerce sales reach $5.6 billion a 14% increase year over year. In our contract segment electronic sales now represent 88% total sales. For North American Delivery overall e-commerce sales represent 75% of total sales.

Q4 operating income increased to 15.4% excluding the extra week in 2006 to $205 million as we increased operating margins 32 basis points year over year to 11.9%. Operating margin benefited from our supply chain improvements and leverage of G&A. Our supply chain team did a great job in 2007 leveraging logistics costs significantly throughout the year which played a major part in driving NAD’s operating margin improvement. Their efforts are also paying off with all time high customer service metrics.

We continue to build up our supply chain to support the Delivery segments impressive growth. The three fulfillment centers we opened in 2006 ramped up smoothly in 2007 and are new fulfillment centers in Nova Scotia and Denver opened up very well. In summary North American Delivery continues to deliver by far the best top and bottom line performance in the industry. We’ve done this by building a sales model that excels at winning and retaining customers and is supported by a world class supply chain and terrific customer service. We believe these efforts will sustain strong top line growth and margin improvement into 2008 despite the market conditions.

I’ll now turn the call back over to Ron to discuss results in our International segment.

Ron Sargent

In the International segment we rapped up a strong year with another quarter of solid operating margin improvement. Overall sales for the quarter grew 18.1% and that excludes the extra week in 2006 to $812 million. In local currency sales grew 7.9% excluding the extra week. We grew operating income a lot faster than sales increasing 53% to $55 million as operating margin improved 155 basis points to 6.8%. For the full year sales were up 17.6% again excluding the extra week to $2.7 billion or 8.1% in local currencies. Operating income more than doubled to $98 million. Operating margin improved 154 basis points excluding the extra week to 3.6%.

All the improvements that came from our operations in Europe where margin improved nearly 200 basis points to 4.6%. Our Retail and Delivery teams there did a superb job of focusing on the levers that will get us to a 7.5% operating margin. Their hard work has put us well on the way to achieving this goal. In Q4 our European retail business saw somewhat softer local currency top line growth, comps declined 1% primarily driven by weakness in the Netherlands that more than offset the positive comps that we saw in the UK and in Germany and Portugal. Margin held up well despite the slower sales as we continue to focus on profit improvement. During the quarter we opened two stores in Europe bringing our total store count to 268.

Taking a look at our European catalog business for the quarter, sales continued to improve mainly as a result of improving customer experience. Service levels are now at a all time high and our customer satisfaction ratings hit their highest level ever. Geographically we saw the strongest trends in Italy, Spain, UK, Scandinavia and Germany. We significantly increased our e-commerce penetration in sales as the upgrade of all our European websites has now been completed.

Turning to markets outside of Europe and China we’ve begun a Delivery operations in the Pearl River Delta region in the Southeast China and now serve Shanghai, Beijing and ShenZhen [Wanjog] the three leading markets in China. Our base of retail stores continues to expand as well. We now have 28 office product stores, two Staples UPS Express stores and two large furniture show rooms. The furniture show rooms allow us to capitalize fully on our position as the exclusive supplier of office furniture to the 2008 Beijing Olympics. Finally we opened our first large scale fully automated distribution center in Shanghai.

In India we launched our first two Staples branded franchise stores with Future Group our joint venture partner. The stores are located in Bangalore and feature a large assortment of supplies, technology and furniture. Over the next year we expect to continue to open large format franchise stores in major cities. We also opened our first store within a store in a big bizarre and plan to expand this concept in 2008. Our Delivery business is also off to a great start in India.

Our operations in South America had a difficult year in 2007. Argentina continued to perform well but Brazil struggled with declining sales and profits for the year. We made a lot of changes in Brazil to set us up for much better results in 2008. Looking ahead in 2008 in International our strategy remains on track. We will again focus on driving margin improvement in our European businesses and growing our businesses in emerging markets as fast as possible while still breaking even.

I’ll now turn the call over to John to discuss the financials.

John Mahoney

Good morning. I’ll review the details of the financial statements and explain what drove our results, then wrap up with some guidance for 2008. Before I begin I want to quickly remind you about the one time items from Q3 2006 and Q3 2007 which are laid out in our earnings release. As I talk about the full year results I’ll exclude these items. Last year in Q3 we recorded a $10.8 million expense or $8.6 million net of taxes related to historical stock option grants. Also in Q3 2006 we recorded a $33.3 million reduction in income taxes. Last quarter we recorded a $38 million expense or $24.3 million net of taxes to settle a wage an hour class action lawsuit.

Turning to the P&L Q4 revenues of $5.32 billion were up 8.3% versus last year’s adjusted fourth quarter. Currency boosted sales by about 340 basis points but local currency growth was 4.9%. For the full year sales reached $19.37 billion an 8.9% increase excluding the extra week last year. Adjusting for the positive impact of foreign exchange of 230 basis points growth for the year was 6.6%. During the fourth quarter gross margin decreased 35 basis points to 29.1% driven by lower product margins and de-leverage of occupancy costs in North American Retail which were partially offset by improvements in North American Delivery and International.

The full year gross margins remained flat at 28.7% as North American Delivery supply chain improvements and better product margins in both North American and European Retail could not offset de-leveraging occupancy costs in North American Retail. For the fourth quarter operating and selling expenses leveraged 10 basis points to 15.5% versus last year’s fourth quarter. For the full year operating and selling expense improved 14 basis points to 16.2%. For both the quarter and the year our results reflect the great job our North American Retail team did in managing expenses particularly in the labor line.

Improvement also came from operational efficiency driven by our process excellence program and lower bonus expense. These gains were partially offset by the de-leverage of fixed expenses on softer sales in North American Retail. Turning to G&A, G&A for the fourth quarter leveraged 42 basis points to 3.8% and for the full year G&A leveraged six basis points to 4.2%. The improvements in both the quarter and full year are primarily due to lower bonuses and tight expense controls.

For the quarter operating income increased to 10.5% or $516.9 million. Net income increased 10.6% to $333.2 million and earnings per share increased 14.6% to $0.47 per share. For the full year operating income increased 11.8% to $1.6 billion net income increased 11.6% to $1 billion and earnings per share increased 14.5% to $1.42.

Moving on to the balance sheet. We are proud of our inventory results holding inventory per store to its lowest level in many years. Although we manage our inventory well sales fell short of what we had planned for during the year and our turns fell 30 basis points versus last year to 5.6 times. RONA dropped 50 basis points to 13.8% driven by the impact of the one time items and the added leverage of the extra week in 2006. To recap our liquidity and financial resources at the end of the fourth quarter Staples had $2.1 billion in liquidity composed of cash and short term investments of $1.3 billion and available credit of about $800 million.

Capex for the year came in at $470 million down from the $528 million we spend in 2006. This decrease primarily reflects fewer store remodels in North American Retail and lower spending on supply chain infrastructure in North American Delivery. The decrease in capital expenditures combined with better inventory management and improved processes around the collection of vendor receivables drove record free cash flow of $891 million. Our strong cash flow gave us the ability to both fund growth and return value to shareholders through a mix of buy backs and dividends.

During the fourth quarter we repurchased a total of $183 million of Staples stock or about 8.3 million shares. This brings our total 2007 repurchases to about $750 million or about 31.6 million shares. Our share repurchase program has been effective in reducing our share count as weighted average shares outstanding declined by 16 million shares year over year. About 1.1 billion remains on our current share buy back authorization.

Based on our strong 2007 performance and expectations for continued earnings growth Staples Board of Directors increased our annual cash dividends to $0.33 per share to shareholders of record on March 28 payable on April 17th. This is a 14% increase from the dividend we paid in 2007. As we stated at the end of our Q3 earnings call we remain cautious about the economic climate that hampered sales in 2007.

We struggled this past year to forecast the business in such a tough environment and our visibility going forward is not any better. We are more guarded in our outlook for 2008. When we talked to you last quarter we believed the slow sales environment might turn around by mid year as the credit crisis looked like it would get cleaned up by then. It now looks like it could take a little longer and we are running our business with the expectation that sales trends won’t materially improve in the second half of the year.

We expect negative comps could continue well into 2008. For the full year we expect mid single digit sales growth and high single digit earnings per share growth with a tougher first half of the year. Our business and our industry remain strong and we are optimistic about our future, our competitive position and our opportunities to improve our business. We continue to gain share and we expect the industry to grow faster than GDP. As a result our long term expectations for strong sales and earnings growth remain unchanged.

Thanks for your time this morning and I’ll now turn the call back to our conference call moderator for the Q&A session.

Question & Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Oliver Wintermantel with Morgan Stanley.

Oliver Wintermantel – Morgan Stanley

I was wondering if you could talk about the working capital outlook for 2008 and what could change in particular versus last year?

John Mahoney

I think that we are very proud of our supply chain team. They have very successfully got the right product to the right place at the right time. As a result we expect as we have a more cautious approach toward sales our buying will not get ahead of our sales as it did a little bit during 2007. In addition, in the areas of collecting on vendor promotional monies as well as collecting receivables from customers we believe some of the process improvement changes there will continue to allow us to improve our working capital. I think that where in a couple of the most recent years our working capital has been a drag on our ability to generate free cash flow we think that its likely to help us during 2008.

Oliver Wintermantel – Morgan Stanley

My second question is can you comment on the competitive landscape on the Delivery side. When you look at your own business did you gain any market share in the fourth quarter? Can you comment on the overall economy and what you are seeing out there?

Joe Doody

First of all the competitive landscape has not changed dramatically it’s always been and I think we will always continue to be a pretty competitive industry. We continue to remain disciplined in our approach to the market place. As such our fastest growing area of our Delivery business is the mid market area. We are clearly gaining market share as you can see from our top line growth continues to lead the industry. That’s it in a nutshell.

Ron Sargent

I’ll take a stab on the economy question. As I think you’ll remember we started really seeing the impact of a slowing economy last summer. That slow down seemed to accelerate in the fourth quarter with retail customer traffic down 6% and December being particularly bad. January was better but traffic remains kind of choppy and I feel like we are kind of bumping along the bottom of this recession. We all understand that there is a business cycle but when you look at our job is to grow and to manage our business even during tough times.

Just like I think we were an early indicator going into the recession I believe that we are going to be an early indicator coming out of the recession. At this point we are feeling less confident about our ability to forecast demand and that’s why we’ve revised our guidance for the short term.

Oliver Wintermantel – Morgan Stanley

A follow up on that, did you see any geographic differences across the country in retail dollar or delivery side?

Joe Doody

I think geographically certainly some of the sun belt markets are being impacted a little greater than the rest on average. In general it wasn’t a dramatic difference. We did the calculation to see what percentage of our business was in Florida and California and I think the number is about 19% of our retail business is in those two markets. We didn’t see any kind of broad differences between those two markets and everything else.

Operator

Your next question comes from the line of Danielle Fox with Merrill Lynch.

Danielle Fox – Merrill Lynch

I was wondering if you could talk a little bit more about the core supplies trends at Retail. Correct me if I’m wrong but it seems like that was one area in particular in Retail that slowed sequentially. I’m wondering if you could comment on what you think is going on from a demand perspective and how that affects the gross margin mix at Retail?

Mike Miles

We did see some slow down in the fourth quarter, some of that due to the fact that we had pretty good supply sales in the third quarter associated with back to school. Also I think some of it associated with the general slow down that we seem to be seeing across the business. We are working real hard to drive, in particular the ink consumables business which is one of the destination categories for us that produces a basket of other office supplies.

By all the evidence that we have we are still gaining share very strongly in the ink and toner space. We think that has a good carry over to the rest of the supplies category. In general supplies performed pretty well given the overall economic situation. The Dell ink piece has been a nice boost for us and as I mentioned as we advertise that right now on television it’s showing very healthy growth and is helping with the whole ink category for us.

Danielle Fox – Merrill Lynch

How about the margin mix, is it fair to assume that the core supply business, while slower, is still comping better than the average so the margin is not trending down as quickly?

Mike Miles

The categories that are really slow are durables categories, furniture being the worst and that’s probably the one mix thing that’s hurting us the most it’s a relatively good margin product. Some of the other non-computer tech durables are down as well and those are lower margin products. In general the mix has been okay as the supplies are holding up better than some of the tech durables.

Danielle Fox – Merrill Lynch

How dependent is the International profit recovery on sales improvements, how long do you feel like you could withstand a weak demand environment in Europe specifically without compromising the substantial margin recovery that we’ve been seeing.

Ron Sargent

I think the short answer to that is we could withstand softer sales for years. When you look at the kind of progress we’ve made this year I couldn’t be happier about the progress the team has made over there. Anytime you double your profits in a year I think you’ve got to feel pretty good about it. We feel like in 2008 we can continue to make good progress on the bottom line even if the economy starts to slow. If you look at our share of market it’s very small in Europe.

I see this as not a top line story as much as it is about the basics of better buying, reducing G&A and improving the supply chain and selling more Staples brand. All the credit goes to our European team but I think they’ve done a great job of improving profitability while not seeing as good of robust economic climate as they saw a year or so ago.

Operator

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

Colin McGranahan – Bernstein

My first question focusing on the Retail business, I thought it was particularly impressive performance to keep market erosion. Mike I think you said 20 basis points on an adjusted basis. Could you get more specific about how you manage to keep margins relatively flattish on a negative six comp? Could you talk particularly about any impact of incentive comp or other things that are non-recurring?

John Mahoney

Mathematically the margin improves because of some of the faster growing categories like Copy and Print and our EasyTech businesses which have higher margins than the business as a whole. Mike talked a little bit about the mix in other categories where we saw the supplies hold their own versus the tech durables and furniture saw a precipitous decline. I think the mix overall was favorable. The other thing is that as we looked at our promotional activities in the fourth quarter we did not try and chase laptop sales, for example at the expense of our margins.

We constrained to some degree some of the categories that were highly promotional particularly during the holiday season. That was reflected in a weaker December. Having a good understanding about what kind of product mix you want to drive as well as pretty good selling skills in our stores that kept our mix attractive and allowed us to maintain the margin that we saw in the fourth quarter.

Colin McGranahan – Bernstein

Obviously EasyTech is very small and Copy and Print given the growth that couldn’t have been more than 10 or 15 basis points by my math, correct me if I’m wrong. It really was less promotional activities the big driver to offset the de-leverage?

John Mahoney

I would agree with that.

Mike Miles

The other thing that I would say is that all of the other lines in the P&L we have been working on real hard, we are a little more out in front of it than we were in the first half of last year. Whether it’s other operating expenses or store labor or marketing, we are working real hard right now.

Colin McGranahan – Bernstein

If you continue at a negative mid single digit rate you’ll begin to anniversary some of those great efforts on the other lines of the P&L maybe mid yearish?

John Mahoney

There is always an opportunity to get better and I’m astounded by the creativity and determination that our teams have shown in being able to, through process improvements and other activities continue to get more efficient. Certainly it gets harder, gross margin is a very important part of our total business model and if sales go down forever that’s going to be a problem. We are planning, as I mentioned in our outlook for a relatively difficult 2008 and as a result our expense controls will continue to be very, very strong. I don’t think that we expect to see any lack of continued effort to try and maintain profitability rates in spite of the fact that sales are slow.

Colin McGranahan – Bernstein

I understand and I was particularly impressed and I wanted to understand the drivers of it. Finally, given you are now about a year into the stand alone Copy and Print stores, you’ve got a couple New York stores opened it sounds like in the 100 stores for next year you’ve got plans for at least a few more, can you give us a quick update on where you stand with the potential for that concept and any more specific things you’ve learned?

Demos Parneros

With respect to the stand alone Copy Center stores they are definitely well received by customers, small business customers particularly love them. We are able to track to larger customers in our normal copy center stores. We’ve taken a lot of good ideas from those stores, for example business cards in minutes initiative that was discussed earlier is something that we actually tested in those stores. We’ve got six up and running right now in the US in addition to the Canadian stores and there are plans to open probably five or six more at this point over this year. I think we are learning a lot, they are building very nicely; the customer reception is probably the biggest win for us. It’s got good promise.

Operator

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

Matthew Fassler – Goldman Sachs

I’d like to ask the first question by following up on Retail gross margin. To get some clarification John I think you said product margin was down. It seems like mix wasn’t really the issue. If you could give us more color on helping us get to that decline?

John Mahoney

When you look at the gross profit line which is what we report in the financial statement, de-leverage occupancy was the biggest driver for that. Product margin was pretty good.

Matthew Fassler – Goldman Sachs

Product margin was not down?

John Mahoney

That’s right.

Matthew Fassler – Goldman Sachs

I want to ask a question that sort of skims over the Corporate Express issue that that is what’s your thought process on buying back stock during the interim period while this proposal is being considered?

John Mahoney

I think we said we aren’t going to comment on the Corporate Express transaction overall. We’ve been clear on our capital structure philosophy we expect to try and continue and maintain investment grade credit rating and as we determine where we’ll go with Corporate Express we’ll certainly have to take a look at all of the elements of the capital structure as we decide how to finance the transaction if we are lucky enough to be able to close on it.

Matthew Fassler – Goldman Sachs

Final question, in terms of your revenue guidance for 2008 could you give us any color on what you expect by business particularly for Delivery?

John Mahoney

No we didn’t and I think the reason for that is that as we said our visibility has surprised us during 2007 and you saw the results by business unit sequentially compared to the third quarter and while as Ron said we think things aren’t going to get a lot worse, we really had expected that we’d see a little bit more optimism with the credit situation clarified itself by certainly mid year and it doesn’t look like that’s going to happen to us right now. A rebound is something that we are reluctant to predict right now.

Matthew Fassler – Goldman Sachs

As I look at the Retail business versus Delivery business it seems like you had more deceleration in Retail from Q3 to Q4 than you did in Delivery though Delivery decelerated a bit. Do you have an expectation for while holds in versus the other in terms of where the macro impact could be felt more?

John Mahoney

Isn’t that the same question you just asked?

Matthew Fassler – Goldman Sachs

Twisted a bit differently.

Ron Sargent

If you look at the business over the last several years our Delivery business has grown nicely and has performed better on the top line than our Retail business and we expect that to continue.

Operator

Your next question comes from the line of Dan Binder with Jefferies.

Dan Binder – Jefferies

A couple questions, first I realize you don’t want to put a lot of color around the full year revenue line item by nature category but could you give us a rough idea in terms of current trends now and how we should be thinking about the North American Retail and Delivery trends as we are now about a month into the current quarter? Also on store growth a lot of retailers have opted to cut square footage growth as it appears that this consumer down turn may be a little bit more extended than originally thought. I’m curious why in this industry where we seem to be a fairly mature level you’ve opted not too? Lastly, based on your current guidance what the free cash flow should look like on ’09?

John Mahoney

We expect that negative comps will continue well into 2008 and so the full year we expect mid single digit sales growth throughout the year with the second half being a little bit better than the first half. Ron commented on by business unit was you should expect to see and the fact that we believe that things are not getting a lot worse and that’s our basis for our guidance for the full year is what we are seeing so far this year.

Ron Sargent

I really wish we had better visibility of being able to predict sales but in the last couple of quarters we haven’t been that good at it. The only good news about soft sales is you have easier comparisons down the road I can’t think of a single other soft sales. We expect the business to perform similarly to the trend going forward.

Mike Miles

On the new store front I think our plan all along is to keep a steady and measured pace. When we were looking at good times and others were ramping their new store plans way up we stuck to the plan that we had. I think we are following the same strategy through this tough time, we don’t see any major change to the long term prospects for the industry and we’ve still got lots of trade areas where we don’t have any metro areas where we don’t have any Staples and also trade areas in markets we are in that are developing into good trade areas for Staples. We want to continue to follow that plan, so 100 stores for us is a prudent thing to do this year, last year and probably next year too.

Ron Sargent

It positions us well when the economy does improve too.

Dan Binder – Jefferies

Any thoughts on the free cash flow this year.

John Mahoney

You know what we expect to see for earnings growth I told you the working capital should be a positive this year so overall you can expect to see the trend in free cash flow that we saw this year continue.

Dan Binder – Jefferies

One final one if you could, on the Delivery business is the sales to existing customers flat, positive or has it moved into negative territory?

Joe Doody

If you really look at our business its pretty simple what’s continuing to go on is, one is our acquisition activity continues quite strong. Our retention also we are very satisfied with. Its all really less frequent orders and smaller orders from our existing customers, that’s what has led to the slow down from Q3 to Q4.

Operator

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

Brian Nagel – UBS

My question relates to sales trends across the enterprise. We’ve seen retail sales slow more as the year has progressed and your delivering contracts trends has held up better. As the slow down progressed in retail have you seen the volume patterns in your delivery of contract channels more similar to retail? The second question on top of that would be is there any way you guys would look at the Delivery business to break apart what benefit market share gains may be having on the overall growth rate versus the buying patterns of some of your existing customers?

Ron Sargent

I think the buying patterns between Retail and Delivery are very different. You look at the Retail buying patterns its just lower customer count. Average ticket and average order seems to be holding on we are just getting less consumers and small businesses and home offices coming to our store. We think that’s a reflection of the economy. In terms of the Delivery business I think as Joe said we are continuing to acquire, we are continuing to grow in the acquisition front but we do have a little bit of an average ticket slow down in terms of average customer.

Joe Doody

We are seeing a little more cautious customer throughout be it small, medium or large size customer ordering a little less frequently and a little bit smaller average order size.

Ron Sargent

Your other question was about the share gain in delivery?

Brian Nagel – UBS

Yes, if we look at Delivery, it has held up well but to what extent do you think share gains are helping to keep that Delivery line stronger for Staples?

Ron Sargent

The vast majority is through share gains are exactly where we are getting the vast majority of our growth.

Brian Nagel – UBS

One other question, I apologize if you addressed this already. Did you say how Retail sales trended through the quarter?

Ron Sargent

We didn’t get very specific but I think we implied that they were ‘u’ shaped, December being the softest month and November and January being better.

Operator

Your next question comes from the line of Gary Balter with Credit Suisse.

Gary Balter – Credit Suisse

I have one simple math question then a different question on strategic direction. On the math you mentioned North American comps were down 6% what does that imply for US, we always work on the assumption that Canada is good and positive.

Mike Miles

Very similar, Canada didn’t help us much or hurt us much for the last couple of quarters. Canadian comps have been roughly the same as US comps.

John Mahoney

Since you’ve moved to the United States overall consumer demand in Canada has declined.

Gary Balter – Credit Suisse

The longer terms question is a strategic question is I grew up in a time when we watched Home Depot in ’90 and Wal-Mart in ’90-’91 in the recession fight to gain share and keep pricing extremely sharp and use it to gain share, we see Costco is still doing that today. You are in a position where you have two competitors with very weak margins and one of them at least with very questionable infrastructure at the current time.

Then we hear on the call that gross margin was fine at the product level and people are congratulating you on only being down 20 bps at retail. Why not take the approach given how strong you are, given how financially secure you are to gain market share in areas like supplies; especially given you’ve moved into some of the heartland of some of the competitors markets?

Ron Sargent

I’ve been here 19 years this month and everything that we’ve determined from how competitors have interacted with each other as well as all the research that we’ve done says that pricing in this industry is not a differentiator. It’s important that you’ve got to have competitive prices and we feel like we do but in terms of what’s important to our customers its not pricing as much as service, quick in and out, great service, in the store in stock, knowledgeable people, those things are a lot more important to our small business customer at retail than if we lower a case of copy paper by $1.

It’s not sustainable either because as soon as you lower your price by $1 everybody else gets competitive and lowers their price by $1. It’s really not a differentiator and we don’t see using price as a competitive tool other than to be very competitive with the market place and we compete with a lot of folks besides office superstores. We compete with Wal-Mart and Costco and Best Buy, the independent dealers. I don’t see price as being the thing you are going to pull out the quiver to start shooting a lot of people, I don’t think it’s a differentiator in our business.

Gary Balter – Credit Suisse

Asked a different way then, what is the differentiator that you need in Retail that separates you? Right now your comps are running about the same level as your competitors and you seem like a stronger company.

Ron Sargent

I think the differentiator has always been in Retail is to give customers great service. Some customers define it differently, some its fast check, some it’s in stock, some its knowledgeable people. The challenge that we are having right now its not taking care of the customer when they are in the store its getting customers to come to the store. We’ve got a marketing challenge or maybe a demand challenge where customers are saying, “I’m going to shop once a month instead of once a week. I’m going to not shop at all, I’m going to run down my supply cabinet.”

The good news is that just like you’ve got to go to the gas station every week, you’ve got to go to the grocery store every week. If you are small business you’ve got to buy office supplies. You can work your supply cabinet down for a while but at some point if you are a small business to stay in business you’ve got to buy envelopes and pens and paper and the basic necessities which ultimately helps us.

Gary Balter – Credit Suisse

One technical question, are any of your cash tied up in any option rate securities, any options that haven’t…

John Mahoney

When you look at the balance sheet you’ll see that we moved all of our medium term, the things that aren’t actually classified as cash, which are typically very short term money market funds and so forth into treasury bills so we don’t have any options.

Operator

Your next question comes from the line of Anthony Chukumba with FTN Midwest.

Anthony Chukumba – FTN Midwest

A couple quick questions on North American Retail, first in terms of the 100 stores that you have planned to open in 2008 what’s going to be the general break down of those stores in existing markets as opposed to new markets? You mentioned there were 10 major markets that you still have not penetrated as of yet.

Mike Miles

We still think about Denver and Miami and even Chicago as new markets. By that definition roughly a third of the stores that we open in the US will be in new markets. Virtually all of our Canadian stores are fill in stores at this point or single store markets. Thinking about 25 or 30 stores being new market stores for us.

Anthony Chukumba – FTN Midwest

But no actual new markets that you are currently not in at all?

Mike Miles

Its been in the press that we’ll have stores opening in Minneapolis and Kansas City and Houston in 2008 and our plan is to frankly be in the market for real estate nationally across North America at this stage in the game we feel like our Staples brand as well as our local store marketing capabilities allow us to open stores and succeed with them and grow them pretty much anywhere in the country. You’ll see us enter some of those 10 cities this year and frankly you’ll see us looking for real estate everywhere in the US and Canada.

Operator

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

Chris Horvers – Bear Stearns

As you think about the fourth quarter you grew earnings 9% ‘x’ the 53rd week last year, you’ve given high single digit which 7% to 9% for this upcoming year. The first half and first quarter in particular how should we think about the ability to grow earnings, it’s a lower revenue quarter which causes more cost de-leverage pressure but at the same time your earlier on and might be able to control costs a bit better. How should we think about that?

John Mahoney

I think you are right, I think the first two quarters are our lowest revenue quarters for the year and therefore it makes it harder to leverage our fixed expenses. That’s part of why we expect to have a tougher first half than the second half of the year. We also expect that while the economy might not be fully back in the second half of the year we are expecting both because of comparisons and also because of the fact that there may be a little bit more strength from consumers and our small business customers that second half will be a little bit stronger as well.

Chris Horvers – Bear Stearns

Should we think about the first quarter as being at the low end of that high single digit range or something below that?

John Mahoney

We described the fact that our visibility isn’t as good as it has been in past times and our general guidance for the year is about as granular as we feel we can be and be helpful to you right now.

Chris Horvers – Bear Stearns

Going at it a different way, we think about the fourth quarter two line items, G&A and the payroll on the Retail side. First on G&A how much of that was incentive, how much of that improvement was incentive comp and how much of that was a reversal of prior year to date accruals?

John Mahoney

We didn’t reverse any accruals, we described the fact that there are incentive comp obviously was not as strong as last year as we didn’t achieve the plans that we had set back when we did the budget in October, before the year began and we thought the economy would be a little bit stronger. While the incentive comp made a contribution there really was a pretty good effort across the board, across the whole company at driving productivity. I think it was mentioned the fact that we’ve had a lot of process improvement initiatives and many of those are very good. Bonus contributed but certainly it wasn’t accrual reversal and it wasn’t the only thing that we did to drive down our expenses.

Chris Horvers – Bear Stearns

Would it be fair to say that 42 basis point improvement would be half bonus accrual or half bonus and half process improvements?

John Mahoney

We typically talk directionally about those things and I wouldn’t want to be any more specific than I’ve already been.

Chris Horvers – Bear Stearns

Finally on the payroll side at Retail, really very impressive job by Demos and the team. How far are we from getting down to a minimum level of staffing that you need to keep the stores open and ready for customers?

Demos Parneros

We’ve got strength given the fee that we’ve been through this challenging time before. I think going at it the way we have very carefully planning ahead, doing an excellent job of using our labor tools that we’ve got in place. Balancing good service and we see our service a lot better than having the bare bones. We saw service scores go up in the quarter which is very surprising and good to see. We talked about investing in the business earlier I think service has been very important to us over the last five years because specifically and we’ve protected our store coverage and providing good service.

We talked about businesses like Copy Center and the growth in EasyTech and those are very difficult to grow without having people there who not only are showing up but know what they are doing. It seems to be a good job on this because it becomes more challenging without sales growth but we know that the way to get through it is to provide good service and keep the customers coming back.

Ron Sargent

I think the tools that Demos and his team use to manage payroll is pretty darn sophisticated and tries to get hours in the store when customers are in the store and I think you’ve done a pretty impressive job managing it.

John Mahoney

I’d just comment on the math to say that the challenge is to eliminate tasks faster than sales go down so that basically you are trying to bring down the base of hours necessary to keep the store open so that you don’t wind up bumping into that category where you’ve got lots of stores that don’t earn enough labor to be able to spend it with the sales that they have. That process improvement effort has allowed Demos to avoid having a large number of stores that don’t earn the base level of labor.

Chris Horvers – Bear Stearns

It sounds like there is still more room in the first half?

Ron Sargent

We hope we don’t need more room in the first half.

Operator

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

Jack Murphy – William Blair

Following up on a couple earlier questions, outside of this investing in service and keeping good service levels in the retail business could you go back and talk about the merchandising priorities for driving traffic in a negative comp environment, the tactical things you are focusing on, where rewards card would be on that list as well?

Mike Miles

The merchants are continuing to try and bring as much news and innovation into the stores as they can. We’ve talked about the success of Dell, we are expanding the M product line this year at Retail, continuing to look for innovation in the Staples brand and so I think you’ll see in terms of new brands in our stores that being a piece of it. Also initiatives like Security which I talked about printing is a big emphasis for us.

Those are areas that the merchants are going outside the normal categories and thinking more about customer solutions as a way to help drive traffic. We think services are a big part of our future growth story both in the Copy Center and with our EasyTech we’ll continue to focus on those areas.

Jack Murphy – William Blair

One last question on how you are viewing capex, we have the situation where you have a lot of competitive store closings, how would you tactically view your capex, should we think about an acceleration even if comps are negative for yourself or more sticking to the current plan?

John Mahoney

As far as capex overall is concerned you saw that we did try and be as aggressive as we could during the year at not spending capital when we saw the weaker sales environment so capital was actually down to about $470 million versus last year when we were about $525 million. Generally speaking that hasn’t come at the expense of store openings, we would expect that regardless of what our competitors do we’d stick with our plan to try and populate the country with stores at the rate of around 100 a year. Our challenge is to try and open up 100 great stores every year and I don’t think anything competitors do would change that strategy.

Operator

Your next question comes from the line of Steve Chick with JP Morgan.

Steve Chick – JP Morgan

A question on your organic NAD sales trends that have decelerated through the year, as you look to next year it sounded like related to retail comps you are saying so far what you are seeing is not worse than the fourth quarter trend. Can you say the same about the organic NAD sales trends as well?

Ron Sargent

I don’t want to get into monthly reporting of organic sales trends. Joe you want to give a little color to that.

Joe Doody

We’ve definitely seen a slowing of our organic growth trend throughout the year but our distance from our competitors continues to stay in tact. We feel that our market share growth is continuing yet at the same time we are seeing a slowing of sales to existing customers. We are continuing to stay focused on driving new customer account acquisitions, continuing to stay focused on driving more share of wallet with an existing customer for categories they are not buying from us. We’ll expect to see an improvement when the overall macro environment improves to continue to get core product sales moving more positively again.

Ron Sargent

Just like the last recession it seemed like during the last recession we continued to add customers and the acquisition turned out to be very good for us when the economy improved.

Joe Doody

Not holding back on that investment as much as possible this year.

Steve Chick – JP Morgan

Second, I don’t want to touch too much around the sensitivities what’s being proposed with CXP. My bigger picture question around it is there has been some to date on the synergy of like contract delivery abroad versus in your case NAD here or a US based supply business. Right now you could service that business through alliances in some cases I think you do currently.

Ron Sargent

Sure, with Lyrica.

Steve Chick – JP Morgan

Can you speak broadly on is there a lot of synergy between operating a US based like business and international based business? Hypothetically how would you deal with the alliances that you have currently in place?

Ron Sargent

Its way premature, at this point. I think we were very public about our intent and our plan and our goal. We said in the press release it’s a great deal for Corporate Express share holder, it’s a good deal for Staples share holders as well. We believe that we’ve offered a very full and fair price for the business but in terms of figuring out what might happen or could happen or maybe will happen I think its way premature at this point. Sorry but I’m not going to give you a whole lot more than that.

Operator

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

Joe Feldman – Telsey Advisory Group

I wanted to ask you a little bit about Europe and because we haven’t touched on it too much in the call, what your outlook is given the slow down in the economy over there, particularly in the UK and how you are planning the business over there? In addition, what you are thinking for store growth internationally given the expansion in China and India and everything else.

Ron Sargent

In Europe we are going to manage the business tightly just like we have here in the US. I think there is probably some learning’s that we can apply to our European retail business. Over there it’s about two third retail about one third delivery. If you look at the UK in particular UK is probably where we saw the greatest improvement in our profitability this year. We had positive same store sales in our UK Retail business for the quarter and for the full year.

What we are seeing a bit of slowing in the Netherlands but we are still positive same store sales in Germany as well as Portugal. Belgium is just a start up operation. Again, delivery seems to be growing nicely. We are not immune to the fact that a lot of times the economy in Europe is similar to the US after some period of time and we are planning for that. Like I said earlier I think the play is not so much sales at all cost as it is profitable sales and managing and operating the business better.

In terms of new store growth for the year in Europe I think it will probably be something around 10 or maybe a few stores less than 10. We are not planning on new store growth being a big driver of our results in Europe in 2008 but we are immeasurably getting closer to the 7.5% operating profit and when it starts to look very profitable in Europe that’s when we will plan on stepping on the gas. It’s probably not going to be in ’08 in terms of store growth.

Operator

At this time I would like to turn the call over to Ron Sargent for closing remarks

Ron Sargent

I’d like to close by thanking the Staples team for delivering pretty good results for the year despite many challenges. As you look ahead we are certainly prepared for a difficult environment in 2008 but we’ve certainly weathered difficult times before. We know we can succeed in a pretty tough environment by sticking to the plan which is investing in growth, operational excellence and taking great care of our customers. Thanks everybody for joining us on the call this morning.

Operator

Thank you for your participation in today’s conference. This concludes the presentation you may now disconnect and have a good day.

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Source: Staples, Inc. Q4 2007 Earnings Call Transcript

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