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Office Depot, Inc. (NASDAQ:ODP)

F1Q08 Earnings Call

April 29, 2008 9:00 am ET

Executives

Steve Odland – Chairman, Chief Executive Officer

Charles Brown – President, International

Chuck Rubin – President, North American Retail

Steven Schmidt – President, North American Business Solutions

Brian Turcotte – Vice President, Investor Relations

Analysts

Matt Fassler – Goldman Sachs

Colin McGranahan – Sanford Bernstein & Co.

Oliver Wintermantel – Morgan Stanley

Daniel Binder – Jeffries & Co.

Michael Baker – Deutsche Bank

Steve Chick

Operator

Good morning and welcome to the first quarter 2008 earnings conference call. All lines will be in a listen only mode for today’s presentation after which instructions will be given in order to ask a question. At the request of Office Depot, today’s conference is being recorded.

I would like to introduce Mr. Brian Turcotte, Vice President of Investor Relations who will make a few opening comments. Mr. Turcotte you may now begin.

Brian Turcotte

Thank you, Wendy. Before we begin I would like to remind you that our discussion this morning may include forward-looking statements which are subject to the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements reflect the Company’s current expectations concerning future events and are subject to a number of factors and uncertainties that could cause actual results to differ materially. A detailed discussion of these factors and uncertainties is contained in the Company’s filings with the SEC.

I would now like to introduce Office Depot’s Chairman and CEO, Steve Odland.

Steve?

Steve Odland

Good morning. Thank you for joining us for Office Depot’s first quarter 2008 conference call. With me today are Charlie Brown, President of International and Acting CFO, Chuck Rubin, President of North American Retail and Steve Schmidt, President of North American BSD and of course Brian Turcotte, Investor Relations.

The press release and the Company web cast slides for today’s call are available on our web site at www.OfficeDepot.com, click on Company Information and then Investor Relations.

As you may recall, the first half of 2007 was a record period for us from both a sales and a margin perspective as our efforts for improved performance were successful prior to the slow down in the macroeconomic environment.

In the first quarter of 2008 our results were better than we expected. The business environment remained challenged in the first quarter but roughly comparable to the fourth quarter of 2007. However, we focused on the factors we could control and in the first quarter we continued to execute our strategic initiatives. The first quarter 2008 total company sales decreased 3% compared to the first quarter record results last year.

Net earnings on a GAAP basis were $69 million compared to earnings of $154 million in the first quarter of 2007. GAAP eps on a diluted basis were $0.25 for the quarter versus $0.55 a year ago and $0.07 for the fourth quarter of 2007. As adjusted diluted eps for the first quarter were $0.29 versus $0.59 in the same period last year and $0.10 in the fourth quarter of 2007.

Total company operating expenses as adjusted represented 26.6% of sales, an increase of 140 basis points from last year. EBIT as adjusted as $124 million for the first quarter of 2008 or 3.1% as a percentage of sales compared with $246 million or 6% from the same period last year.

EBIT margin was better than expected for the first quarter including 290 basis points sequentially due to much improved results in the North American retail and North American Business Solutions Divisions.

On our previous earnings call the Division Presidents walked you through their action plans to improve performance in each of our three businesses. Today each of them will provide an update on the progress we have made thus far.

I’ll now turn the call over to Chuck Rubin to talk about North American Retail.

Chuck Rubin

Thanks, Steve. First quarter sales for the North American Retail Division were down 7% to $1.7 billion. Comparable store sales in the 1,169 stores in the U.S. and Canada that have been open for more than one year decreased 9% in the first quarter. Florida and California continue to weigh heavily on our results as our Small Business customers in these two markets continue to be disproportionately impacted by difficult housing related economic conditions. Combined, these two states represented approximately 26% of our total store sales and 35% of our comparable store sales decline in the first quarter.

Outside of these two states we have also seen deterioration over the last couple of quarters in other markets with housing related issues. Other drivers negatively impacting comparable sales included competitive intrusion of 60 basis points, cannibalization from the new store build out of 30 basis points, and a shift in the Easter holiday from the second quarter of 2007 to the first quarter of 2008. Office Depot’s unit market share as measured by the NPD group increased slightly within the office supply market for the first quarter of 2008 versus the same period a year ago while the dollar share was down slightly.

This dollar share decrease was primarily due to our office supply competitors expanding their technology offering. Our design, print and ship services business and furniture business both gained dollar share and unit share. Importantly, as the quarter progressed we gained market share across all of our businesses as our taking care of business efforts took stronger hold.

Operating profit in the North American Retail Division was $82 million for the first quarter of 2008, a decline from the record high $152 million in the same period of the prior year. Operating profit as a percentage of sales was 4.8%, down 340 basis points from 8.2% in the prior year period. However, our margin was better than we outlined during our fourth quarter 2007 earnings call with a 340 basis point improvement sequentially.

The component to the operating margin decline versus a year ago included three key factors. They are as follows: First, approximately 200 basis points of the decrease in operating margin was due to a challenging promotional sales environment especially within our technology offering. We also increased inventory clearancing. However, this increase in sales of lower margin clearance items had a negative impact on product margins compared to the first quarter of the prior year. Partially offsetting these factors, however, was an increase in private brand sales which had a positive impact on product margins and total profit in the first quarter of 2008 compared to the same period one year ago. The second factor was the de-leveraging of our fixed property costs which lowered our margin rates by 110 basis points. The third factor was an increase in operating expenses which reduced margins by 30 basis points. This increase was driven by higher pre-opening expenses partially offset by controlling payroll and advertising expenses. Higher store opening costs were due to opening 45 new stores and relocating one store during the first quarter. This is approximately three times as many new stores in the first quarter of 2008 compared to the first quarter of 2007 and as we previously stated most of these openings were delayed from the past fourth quarter.

These store openings brought our store total count to 1,267. We anticipate opening approximately 25-30 additional new stores over the balance of the year. Although we see significant opportunity to expand our footprint over the long term, we have tempered our overall roll out strategy in response to the current economic environment and are only opening those stores with existing commitments. In the first quarter we moderated the number of store remodels to only one due to the higher than normal level of new store openings. As of the end of the first quarter approximately 55% of our chain, or 690 stores, were operating under the M2 format. Our goal remains to have most of our North American Retail stores in the M2 format over the next few years.

Comparable average sales per square foot in the first quarter were $233 and the average order value remained relatively flat for the first quarter and so once again the entire comparable sales decline was due to lower store traffic.

I would now like to update you on the progress we have made in our action plans to focus on taking care of business in North American Retail.

First, we are in the process of improving our product value offerings for micro-business customers which we define as businesses having less than 10 employees. We have improved our in-stock position by increasing inventory levels of our highest velocity SKU’s such as ink and paper.

Year-over-year we have made significant progress on this metric. We have accomplished this while still lowering our overall first store inventories. We have also been modifying our assortments to deliver increased value especially in our core supplies areas. We have increased our assortment of smaller pack sizes, expanded lower entry price points, added limited time bonus pack offers and remerchandised the high traffic areas of our stores to better highlight these great values.

Second we have focused on increasing the loyalty of our most valued customers. Our recently redesigned Worklife Rewards Loyalty Program, which we believe is industry leading, continues to grow its membership. The program provides our micro-business customers a better value proposition on the products and services they buy the most including our core high margin supplies. We have also expanded the benefits to our customers by providing Worklife Reward Only pricing, targeted promotions in limited time financing options.

This is all reinforced with new enhanced customer service programs intended to provide better customer service. Once again, during the first quarter, our customer service index scores which are measured by an independent third party improved compared to the same period last year and sequentially to all time highs.

Finally, third we continue to address micro-business customer needs by enhancing our service offerings to complement our product assortment. Today our tech people service offering is available nationally at the customer’s work or home locations. The service will ensure that virtually any technology product is set up and working properly at their place of business. We also anticipate expanding our current in-store service test nationwide over the course of the year. This offering provides our customers with a one-stop shop for a wide variety of services including PC tune up’s and repairs, data protection and new software installation. To date we are very pleased with the performance of the service offering and have received very positive feedback from our customers.

Additionally, our operating model is a very cost efficient way of servicing the micro-business customers in a small, yet fast growing market. Additionally, during the first quarter our design, print and ship services business experienced positive sales growth and gained market share as we continue to roll out new services like large format and full color business card printing and made operational improvements to the business.

However, toward the end of the first quarter a number of our competitors became significantly more price promotional within this category. At this point we remain focused on our exclusive Xerox Certified Print specialists, our strong offering to the targeted micro-business customer and our guaranteed quality and on time promise.

As we look to the second quarter we will continue to manage our operating expenses tightly as we have in past quarters. However, the second quarter has historically been our lowest revenue quarter during the year due to seasonality. We do see sales challenges continuing which will result in operating margins being lower than the last year. We remain focused on our taking care of business plan and based on our current sales forecast we expect our second quarter operating margin to decline versus record levels in the first half one year ago before improving in the second half of this year.

Now I’ll turn the call over Steve Schmidt.

Steve Schmidt

Thanks Chuck. As I mentioned during our fourth quarter earnings conference call we were lapping some difficult comparisons in the first quarter of 2008. In the first quarter of 2007 our Business Solutions Division delivered record sales results and the best gross margin for any quarter in the year. Total sales in the North American Business Solutions Division were $1.1 billion, down 5% compared to the first quarter of last year. Sales to small to medium sized customers were down 12% partially offset by 3% sales growth with large, national account customers and 4% growth in sales to the public sector.

Business Solutions business in Florida and California, which accounted for about 30% of the Division’s sales in the quarter continue to be soft among small to medium sized customers. In the first quarter these two states were down 10% making up nearly 2/3 of the Divisions’ total sales decrease versus the same period last year. Sales in the first quarter were also impacted by the shift of the Easter holiday into the first quarter, resulting in fewer selling days versus the same period a year ago.

The North American Business Solutions Division had an operating profit of $60 million for the first quarter of 2008 compared to $72 million for the same period the prior year.

Operating margins decreased 80 basis points to 5.4% in the first quarter versus the same period one year ago but we improved operating margins 530 basis points sequentially. Approximately 70 basis points of the decrease in operating margin from the first quarter of 2007 reflect a combination of higher incentives, some cost increases that could not be fully passed through and a shift in the sales mix to lower margin customers and products.

These negative factors were partially offset by a reduction in selling costs which resulted from the redesign of our sales force in response to the anticipated slow down in the economy as well as lower advertising expenses.

I would now like to update you on our action plans that are focused on taking care of business in the North American Business Solutions Division. First, the pilot test of our behavior based customer contact strategy has been going very well and we are starting our national roll out of the tools and processes this month with the implementation being completed by the end of the third quarter. This program will ensure that we have the right content, catalog, online, email and overall contact strategy to optimize revenue and profit.

Second our outbound selling telephone account management or TAM organization is performing better. Some of our best former sales representatives have been hired by a third party firm and preliminary results are encouraging with their revenue performance outpacing the results of our other TAM representatives. We have become more active in working with our vendor partners and have new key performance indicators in place to measure every rep’s effectiveness. We have also recently hired a new leader of our TAM organization who has significant experience within the industry.

Third we have assembled a completely new team within our catalog direct marketing and changes are underway. All print and online marketing vehicles have been evaluated and are in the process of being re-prioritized for improved revenue and profit contribution. We have increased our catalog circulation to drive revenue and early results 6-8 weeks after this push are encouraging. We will continue this catalog focus for the balance of the year increasing the number of mailings in the second quarter. Combining this focus with a revamped online advertising strategies will improve spending efficiencies across the direct business in 2008 and I am encouraged by the early trend.

In addition we continue to focus on specific margin enhancing and productivity initiatives including an initiative to simplify customer price plans and place stricter controls on account level prices. This contributed to operating margin growth in the first quarter.

Our Internet sales on a global basis continue to grow in 2008 with sales in the previous twelve months totaling $4.9 billion compared to $4.5 billion for the same period a year ago. For the first quarter 81% of total BSD sales were online compared to 78% in the same period a year ago.

Second quarter sales are expected to improve from one year ago and operating margins should improve sequentially. However, the year-over-year comparisons will be challenging as we are overlapping the highest operating margin quarter in 2007.

I’ll now turn the call over to Charlie Brown.

Charles Brown

Thanks, Steve. The International Division reported a sales increase of 6% in the first quarter compared to the same period of last year. Sales in local currency decreased by 4%. A slowing macroeconomic environment, primarily in the UK, and a shift in the Easter holiday resulted in fewer selling days therefore negatively impacting sales.

Division operating profit was $60 million in the first quarter compared to $82 million in the prior year’s first quarter as our UK business continued to struggle. Operating margin declined by 230 basis points to 5.3% from 7.6% in the prior year’s quarter, the peak quarter for 2007. The components of the operating margin decline were as follows: First, the continued overall weakness of the UK business accounted for about 160 basis points of operating margin compression. Second, previously discussed continued investments accounted for 60 basis points of margin decline in the quarter. Third, a shift in channel mix accounted for most of the 10 remaining basis points of margin decline in the quarter.

In the UK we continue to operate in a very challenging economic environment with a housing crisis similar to what we are experiencing here in the U.S. As we have stated in previous communications the UK makes up a significant portion of our international operations. Prior to 2007 operations in the UK accounted for about 1/3 of the Division’s sales but almost half of the operating profit. Improvement in the Division’s performance is dependent upon a turn around in the UK and as a result of our intense focus all of our customer service metrics improved in the first quarter. We are focusing considerable effort to ensure that despite a challenging economy we show improvement beginning in the second quarter.

I would now like to update you on our action plans that are focused on taking care of business in international. First, the customer service and call center issues in the UK are improving. The metric for on time and complete performance is now close to 90%. Although this is not acceptable we continue to make progress. The warehouse and call center consolidation and back office transitions are complete. We are rolling out our delivery management software solution throughout our distribution and transportation network. This will facilitate better execution and significantly improve our on time and complete performance just as it did in the U.S.

In addition, we continue to develop and execute innovative marketing tactics to maintain and get more out of our existing customer relationships and reacquire lost customers. Second, we are maintaining a sharp focus on execution and getting significantly more productivity out of our existing assets. As I stated on our fourth quarter earnings call we have successfully transitioned all back office transaction accounting functions from the UK to our Captive Shared Service facility in Eastern Europe. We have completed the same for France and expect to have the rest of Europe transitioned by the end of this year.

We also continue to consolidate our warehouse footprint in Europe with two new warehouses opening in the second quarter; one in Germany and the other in the Netherlands. This will allow us to further consolidate our distribution network in Europe, closing three old warehouses in the second quarter and another in October. Third, we continue to take steps to further leverage the global sourcing office we launched last year in China to increase direct import and drive private brand penetration in Europe and Asia. To support this effort we have launched a central distribution center in Antwerp to centrally manage direct import assortments.

Additionally during the quarter we successfully launched our [Quarry] private brand writing instruments in Europe and are encouraged by the reception we have seen from our customers. As we discussed last quarter we continue to limit discretionary operating investments and capital expenditures as we navigate these challenging times.

The focus of most of the investments we will make in the Division in 2008 will be in line with the continued integration of our European supply chain and distribution operations to better support our multi-channel business, remove duplicate supply chain costs and provide flexible solutions to our customers. This is consistent with the message we share with you last quarter and will continue to be our focus.

We have also recently launched [announced] Office Depot along with Reliance Retail Limited, a subsidiary of Reliance Industries Limited, India’s largest private sector enterprise, acquired eOffice Planet, India’s largest independent dealer of office products and services to corporate customers in India. This marks our entrance into India, one of the top fifteen office products markets in the world. While small, this acquisition establishes Office Depot in a leadership position in India and provides us with a national platform that will allow us to serve our global customers who increasingly have offices in India.

The second quarter in International should see a return to global currency sales growth and improvements in operating margins versus one year ago. Third and fourth quarters should also see margin improvement versus one year ago.

That concludes my remarks on the International Business and I will now review our Company’s financial results.

During the first quarter of 2008, we recognized approximately $11 million of charges as part of the plan we announced back in 2005, bringing the total charges from inception in the third quarter of 2005 to $396 million. We anticipate charges of $54 million for the balance of 2008 and $23 million in 2009 for a program total of $473 million. However, future charges may change as future plans are implemented.

Relating to cash flow, during the first quarter of 2008 cash provided by operating activities totaled $127 million compared to $231 million during the same period last year. This decrease primarily reflects a reduction in net earnings of approximately $85 million.

Depreciation and amortization decreased by $8 million quarter-over-quarter as we recognized less accelerated depreciation in charges in the first quarter of 2008. Changes in networking capital and other components resulted in $33 million use of cash in the first quarter of 2008 primarily reflecting the timing of cash payments. This was somewhat offset by reduced inventory levels during the period.

Now for the balance sheet. We ended the first quarter with $182 million in cash and short term investments. Our investments and inventory totaled $1.6 billion globally, up from the same period last year but lower than year-end 2007 levels. Our total inventory increased in the quarter for 2008 was primarily driven by the impact of foreign exchange rates and duplicate inventories for warehouse consolidations in Europe.

In North American Retail, inventory per store was $864,000 down 9% from the end of the first quarter of 2007 and down 10% from the end of 2007 as a result of improved inventory management as well as mitigation of inventory risks through clearance activities. Additionally, inventory levels at the end of the first quarter 2007 reflected initial stocking of hardware and software related to the launch of Microsoft Windows Vista operating system.

Working capital increased by $277 million as compared to the first quarter of the prior year. The majority of the increase is related to the timing of payments, changes in foreign exchange rates and duplicate inventories from warehouse consolidation in Europe.

Our net debt at the end of the first quarter was $567 million.

With that I’ll now turn it back to Steve Odland.

Steve Odland

Thank you Charlie. As we look at the balance of 2008 our three divisions will continue to execute their business improvement plans to counter the macro conditions we face. Sales to date in the second quarter still remain sluggish both in the U.S. and the UK.

Second quarter EBIT margins should be down between 200-250 basis points versus last year, which is a lower year-over-year decline than we experienced in the first quarter. Looking out to the third and fourth quarters of 2008, EBIT margins should continue to improve versus last year. As a reminder, last year in the third quarter we had significant one-time tax favorability that won’t repeat this year. Our normalized tax rate should be about 29-30%.

If we look even longer term in our perspective we remain confident that we have a business model and the plans to execute our key initiatives that can deliver improved results and continue to create value for our shareholders.

Before concluding our prepared remarks this morning I would like to express on behalf of the Board of Directors and all of the associates of Office Depot our sincere appreciation to our shareholders for their support in our recent proxy challenge. Like you, we are not satisfied with the performance of the Company or our share price and we are deeply committed to improving the company’s performance in this challenging environment.

With that I will open up the call for questions.

Question-And-Answer Session

Operator

Thank you. At this time to ask a question please press * followed by 1 on your touchtone phone. You will be prompted to record your name. To withdraw your request you may press * followed by 2. One moment please for the first question.

Our first question is from Matt Fassler. You may ask your question, Sir.

Matt Fassler – Goldman Sachs

Thanks a lot. Good morning. It is Goldman Sachs. The first question I want to ask relates to the corporate GNA line, whether it is on the consolidated PNL or the divisional PNL. It looks like you had a much higher allocation for corporate GNA this quarter versus a year ago. Can you talk to us about what that related to?

Charles Brown

Matt, this is Charlie. We were up about $37 million versus the prior year. The main part of this is charges I think from International where as we closed some of these facilities we are incurring severances. As you are very familiar with in Europe it is quite expensive. We also had some increases in professional and legal fees around the proxy and other sorts of challenges.

Matt Fassler – Goldman Sachs

Got ya. Should we…and those charges are separate from the charges that you broke out, correct?

Charles Brown

The charges for severance are part of what was broken out.

Matt Fassler – Goldman Sachs

Got ya. So to the extent that corporate GNA was up more some of those legal fees, professional fees, etc. were a big part of it?

Charles Brown

Yes. Mainly legal and professional fees.

Matt Fassler – Goldman Sachs

Given that the GNA number was a bigger number than we typically see, by some margin can we think of this as being the kind of run rate? The X charges number as being the run rate we anticipate or should that number come down sequentially as we look out through the rest of the year?

Charles Brown

I think that we will continue to have those sorts of charges for rationalizing our warehouse and call center footprint but we will call those out. Otherwise we are not anticipating a significant increase other than in performance based pay.

Matt Fassler – Goldman Sachs

Got ya. My second question relates to the comments you had about the increased traction you got with the Taking Care of Business program in Retail. Chuck, I believe you had talked about that. Was that reflected in the trend through the quarter or was there some other measure that you have that gave you confidence in the progress of that program?

Chuck Rubin

One, our market share improved in the quarter progressed and second the velocity…the sales velocity of some of the critical items within some of our programs also increased, so those were some of the encouraging signs that we saw.

Matt Fassler – Goldman Sachs

Was the trend, just out of curiosity; was the trend through the quarter consistent? Get better, get worse? I know your market share got better but I’m wondering if the industry lost some momentum as the quarter progressed.

Chuck Rubin

Well I think the quarter in terms of total sales did not improve, but you had an Easter shift that occurred in there, so you really have to consider that as well. As we have talked before the Easter holiday has a negative impact in our business unlike some other retail formats.

Matt Fassler – Goldman Sachs

How big do you think that was?

Chuck Rubin

We think that when you consider the Easter shift and New Year’s also shifted this year over last year we think the trend on a normalized basis in the first quarter was approximately consistent to what we saw in the fourth quarter.

Matt Fassler – Goldman Sachs

Great. Then finally just to clarify, Steve, in BS in delivery did you intimate that you expect to see sales increase year-over-year in Q2?

Steven Schmidt

What we talked about in exact wording was we hope to see sales increase continue to grow as we go throughout 2007 in additional to sequential margin growth throughout 2008.

Matt Fassler – Goldman Sachs

So, just to clarify. I thought you were going to talk about the second quarter. I don’t want to put words in your mouth. Are you essentially saying progressive improvement in the sales trend or are you actually saying Q2 should be actually up year-over-year?

Steven Schmidt

What I’m talking about is progressive growth from a sales standpoint as well as from an EBIT throughout 2008 by quarter.

Matt Fassler – Goldman Sachs

Okay. Thanks so much.

Operator

Thank you. Our next question is from Colin McGranahan. You may ask your question.

Colin McGranahan – Sanford Bernstein & Co.

Good morning. Firstly wanted to follow-up on Matt’s first question there just so I really understand corporate GNA. You reported and broke out $10 million in charges. GNA was up $37 million. If you break out the charges you disclosed in GNA last year it was up to $40 million. Charlie you might understand that the $10 million was the only charge in that $37 million increase so there were other charges that you didn’t break out that you took in there…otherwise is that $27 million increment then just professional legal fees and everything else or were there other charges in that $27 million increase?

Charles Brown

There was another charge related to some severance that we did not include in the charges that had to do with executive level changes here at Office Depot. Also, if we are comparing it to the first quarter of last year there were a number of investments that we made starting with the second quarter for example our office in Hong Kong and the office for Latin America. Those were incremental and would have lapped in the second quarter.

Colin McGranahan – Sanford Bernstein & Co.

Okay.

Charles Brown

It was incremental to quarter one of last year.

Colin McGranahan – Sanford Bernstein & Co.

Right. Okay. And then the…secondly…Steve if you could talk a little bit more about the catalog business? It sounds like as you are getting the context strategy in place you are intending to increase the circulation a little bit. Maybe if you can give us a bit of history on what the circulation has looked like and what your outlook for circulation is? Then your perspective on the ability to actually start to stabilize the catalog top line and maybe even grow that business.

Steven Schmidt

As I stated, we brought in a whole new leadership team around the whole direct marketing area and one of the first things we attacked was the evaluation of our catalog distribution strategy and this includes every aspect of catalogs. We have looked at the pagination of our catalog in terms of look, up sale capability; we have looked at the distribution model of the catalog in our business and found we were under saturating the marketplace from a catalog standpoint. We are using our internal information from a customer standpoint to bring a more focused and targeted approach to catalog in addition to going after many of the small to medium sized customers who in the past we had not been reaching through our catalog offerings. This includes both our small direct customers, as well as our small to medium contract customers. So we will continue to focus on both the efficiency and effectiveness of the catalogs but we are finding some initial results to be encouraging in the first 6-8 weeks of this effort.

Colin McGranahan – Sanford Bernstein & Co.

Okay. And then also Steve could you maybe comment on some of these pricing issues and these public contract [space]? It looks like Nebraska is also reviewing their contract.

Steve Odland

First of all let me talk about the sector in total. This continues to be one of our most important sectors and we continue to grow our business in this key sector of business and what happens is as a result of some initial challenges we received from the state of Georgia, each state contract is being reviewed. We are proactively working with each of the states to make sure that our pricing is accurate and correct with each of the states and in the case of Nebraska also are working and have been working with them with their purchasing department and we hope to have each of these state questions behind us hopefully over the next 30-60 days as we work through this process.

It is a proactive effort on our part. We feel good about our initial results but more will come as we complete this process.

[Not Identified]

Steve, I think it is important to point out that this is as much a political issue in these states as it is a real issue. We have a well organized, well funded small office products dealer association led by some well funded consultants who are out there spreading misinformation and attempting to do damage to all players of the large companies who have won these contracts and we are essentially fighting as much a PR war as anything else. We are aggressively defending ourselves against the misinformation that is out there. But as you can imagine it is difficult to combat these things. So we are proactively going through and auditing all of our business with the states. We are just going out and getting ahead of it and just saying okay we’re going to proactively do this with all of our customers to make sure that we reinstill the confidence and that our pricing is accurate and our service is terrific. We saved these states millions and millions and millions of dollars and I think the small office product dealers are concerned that as we continue to do that we will continue to take business from them and this is the way they have decided to compete.

Colin McGranahan – Sanford Bernstein & Co.

Okay. Thank you. Finally, capEx still on track at $375 million this year?

Steve Odland

Yes. Approximately in that range.

Colin McGranahan – Sanford Bernstein & Co.

Okay. Thank you.

Operator

Thank you. Our next question is from Oliver Wintermantel. You may ask your question please.

Oliver Wintermantel – Morgan Stanley

Good morning. Could you update us on your plans to improve working capital this year versus last year and how do you plan to achieve these goals?

Charles Brown [?]

We have a fairly detailed plan we are working on now to improve our working capital. It started with the decision to curtail anything that was an excess use of cash. We slowed down a lot of our investment spending. More importantly what we are working on is improving our DSO. We would like to improve that by 2-3 days from its current level. We also need to improve our AP to inventory ratio. To go back to 2006 this was really a bright spot for us where we had essentially 100% of our inventory finances through our AP. We have fallen back from that. We are at right about 90% now. We have a full court press, obviously that means working with our vendors which is the biggest opportunity. But those are the two biggest drivers, our DSO and AP to inventory. To get those back up.

Oliver Wintermantel – Morgan Stanley

Okay. That is helpful. Thank you. Can you comment on your goal for your global sourcing effort and what benefits you are expecting in regard to percent of sales being sourced by Asia by the end of the year and maybe talk a little bit about the private label penetration?

Charles Brown

We’ll do this in two parts. I can talk about our China sourcing office, which this is Charlie and that falls under me. But the strategy is really driven by Chuck. This year our sourcing office is already ahead of the levels we had last year and we are right on our plans. We have received…what is really interesting about this is it is giving us the opportunity to receive directly into Europe for the very, very first time. As I commented we opened our own central distribution center in Antwerp. We opened that in December and received our first product in to that. We are accelerating that through the year.

In terms of Asia, we are using the facility in Hong Kong or in [Xian Xen] to actually create mixed container shipments to serve what are really small operations for us in Japan, Korea and China. We’ll do the same thing now with India. So this office is up and running. We’re looking to push even more product through that.

I’ll let Chuck talk about our strategies for the private brand.

Chuck Rubin

I think I would say there are three things that are true of the private brand strategy. We have grown it aggressively over the past couple of years in terms of its penetration level. We still believe there is an opportunity to expand that. So that is one component. Expansion of SKU’s within our assortment across a variety of proprietary brand names.

The second key component is working our private brand strategy globally so the brand names that we offer have moved to a common branding approach around the world and more and more we’re using common factories and where we can we are using common items. Charlie mentioned earlier the introduction of Foray for instance overseas that is one example. So that global orientation in looking at private brands is the second component.

Then to Charlie’s point earlier on direct import as we talked previously directly importing our private brand goods historically has made up a very small portion of our private brand so we think that aggressively growing that over time, we are seeing traction this year but this is not just a one year process. Aggressively expanding this over time allows us to control the features and the product and be sure to stay very focused on what the customer wants. It is also more profitable for us. So that is the third piece in private brand.

Oliver Wintermantel – Morgan Stanley

Thank you very much.

Operator

Thank you. Dan Binder you may ask your question.

Daniel Binder – Jeffries & Co.

Hi. It is Dan Binder. A couple of questions. With regard to the vendors I think on your last conference call you talked about the vendor rebate dollars….or you anticipated the vendor rebate dollars to be similar to what you experienced in 2007. Based on the current sales trends and your expansion of private label and your goals to get working capital up, do you still expect those vendor dollars to look similar to last year?

[Not identified]

What we talked about, Dan was that our percentage contribution by our vendors would be consistent for the full year in 2008 as it was in 2007. Obviously the dollars vary as sales and purchases will vary. Our program level for the first quarter, our monies from vendors which we call program, came in just as we expected them to come in. So there were no surprises from that.

Daniel Binder – Jeffries & Co.

So when you say percentage contribution you mean as a percentage of sales?

[Not identified]

Yes. Purchases.

Daniel Binder – Jeffries & Co.

Purchases?

[Not identified]

But Dan to your point, if we control inventories more and ratchet them down more, purchases decline and therefore program is tied to purchases.

Daniel Binder – Jeffries & Co.

Okay. So just directionally in all likelihood we should expect vendor dollars to come down slightly with inventory coming down? Is that fair?

[Not identified]

Yeah. Yes.

Daniel Binder – Jeffries & Co.

Okay.

[Not identified]

As a percentage of sales or purchases that we measure in a variety of ways, that will stay consistent. So if you remember last year we got hurt in the fourth quarter because of certain purchase tiers that we missed as we slowed down our purchases. We have restructured our programs to this year. We don’t believe we have that risk. But we do know that as purchases go up and down based on how sales go up and down, it will materialize into different dollar levels but the percentages will be consistent with what they were annually in 2007.

Daniel Binder – Jeffries & Co.

Okay. Then the inventory per store was down similar to comps. I’m just curious if inventory overall was up a bit more than the total sales, which were down slightly. Is there any particular part of the business that you point to reconcile that?

Charles Brown

Dan this is Charlie. There are really three components to the overall inventory movement. One was we opened 45 stores during the quarter and that was probably worth about half of the movement. The other piece was in International, the other half. Half of that half or a quarter was [Forex] and compared to the prior year and then as I said in my opening comments we are in the process of consolidating warehouses. What that means is if we built the new warehouse we fully stock that warehouse, we start shipping and then we work the inventory in the warehouse we are closing down. So it just so happens the warehouse in Germany we got caught with double inventory right at quarter end. The warehouse in the UK that we were closing in the fourth quarter was actually favorable. We are actually almost out of the inventory in that warehouse. The inventory in Germany was incremental.

[Not identified]

I think a good way to look at it and an important way in addition to looking at the total as inventory per store in North America, which is why we talk about it that way – most of our stores are in North America, and that inventory per store was down 9% from the end of quarter and first quarter. So that is an important metric.

Charles Brown

That’s right. Had we not improved that performance then the actual increase in the inventory would have been higher.

Daniel Binder – Jeffries & Co.

Alright. Okay.

Charles Brown

Inventory that is in International has been worked down as we consolidate these warehouses.

Daniel Binder – Jeffries & Co.

Understood. Okay. Then on the pricing front, you talked about a little bit of pricing pressure on the copy and print business. Are you seeing that kind of competitive pricing pressure in other parts of the business, domestically or international?

[Not Identified]

On the retail side it is outside of copy and print it has been normal promotional environments. Especially in technology it goes beyond just the OSS channel. We’ve seen that for awhile. That continues and it continues to be especially heated in certain battle ground states like Florida. That has been consistent, not consistent but it has been ongoing for the past couple of quarters. DPS, our design, print and ship depot that pricing…those pricing efforts from a competitive standpoint are new in this past quarter.

Daniel Binder – Jeffries & Co.

Okay.

[Not identified]

[DSE] standpoint North America we have really not seen any what I would call irrational pricing or standard pricing practices that we have seen in the past continue to go forward and there is nothing unique at this point.

Daniel Binder – Jeffries & Co.

Lastly, I was wondering if you could give us a little color around the management hires you have made around the catalog business. Perhaps just backgrounds, where they came from? How long they have been with the company?

[Not identified]

The leader of direct marketing is a gentleman named Jeff Rawling and Jeff has basically 20+ years of direct marketing experience. He brings with him really a total discipline around catalog and online direct marketing, understands every element of direct marketing and the linkages behind that. He has brought on board seven individuals since he has arrived, approximately 90 days ago, and these people bring with them also experience in the catalog online marketing, graphics area, the whole pagination in terms of how to optimize catalogs in their look and feel. It is an area of expertise where if you know the direct marketing space there is some art and science to the direct marketing space. A lot of mathematical and process engineering as you try to analyze each number and each distribution of each catalog and online. So we brought in as part of Jeff’s team we think some really first class individuals who are thinking about and creating a very different business strategy around the whole direct marketing area.

Daniel Binder – Jeffries & Co.

Okay. Thanks.

Operator

Thank you. Our next question is from Mike Baker. You may ask your question.

Michael Baker – Deutsche Bank

Thanks. One and then a follow-up if I could. One, the second half getting better – is it a case of easy comparisons or is it that you believe the economy will get better? Maybe a better way to ask that is the improvement expected to be in sales or more just the profit lines? I guess vendor dollars aren’t going to improve any from the fourth quarter so I’m jut wondering where that improvement will come from. Then the follow-up as it relates to…the second quarter, Steve, you had said margins down 200-250 basis points. Can you just help us on what is the base that you are referring to? There has been some re-statements. I think you included miscellaneous income and EBIT but not an operating profit. I’m just trying to get that 200-250 is down from what margin a year ago? Thanks.

Steve Odland [?]

First of all we are not planning for a change in the macro environment. So the first quarter trends and the second quarter so far as similar to the fourth quarter. I don’t know whether we are at a bottom and we’re just bouncing around here at the bottom or if there is a shelf here off the bottom…it is simply impossible for us to know that. But it appears to be kind of consistent. Sales are not great in the U.S. and in the UK as we have discussed and as we have just reported for the first quarter. So our focus is on margins here. What we said is coming off of our fourth quarter we were going to see improvement in this quarter. We’re pleased we were able to deliver that.

Now the second quarter is going to look a lot like the first quarter in that it is still lapping record levels a year ago and in BSD what Steve Schmidt was saying is that the division operating profit will improve sequentially but still be down versus a year ago because a year ago we had 7% operating margins. I think what Chuck said is that in the second quarter we had record North American retail margins.

So I think what we have got here is a difficult period in time. This is our seasonally lowest quarter in the second quarter. So we’re looking at the second quarter and we’re saying it is still going to be down versus the record level results last year, so it’s going to be similar to the first quarter in that regard. Sales should be relatively flattish in North America and then we think we’re going to start getting better in the third quarter.

As you suggested, part of that is just simply lapping our own results, but we are also looking for sequential EBIT margin improvement in the third quarter in the back half of the year.

So, again we’re not betting that the economy gets better in order for that to happen, but we’re also not betting that it is going to get significantly worse.

Michael Baker – Deutsche Bank

Okay. Fair enough. That makes sense. Then simply if you can…the base of that 250 basis point decline?

Steve Odland

We’re using the pro forma EBIT numbers when we refer to that.

[Not identified]

Removing the charges.

Michael Baker – Deutsche Bank

Got it. Thanks.

Operator

Thank you. Our final question today is from Steve [Chick.] You may ask your question.

Steve Chick

Thanks. I guess two questions. Related, going back to the state government contract question, the sales and BSD for the public sector decelerated from 10% last quarter to it looks like 4% this quarter. I’m wondering if from the contracts you have seen affected to date if that is reflected fully in that deceleration or if your plans are that maybe it gets a little worse? Related to that, is there any way, Steve, can you kind of capture what your percentage of BSD is that is with these government contracts so we can kind of get a feel for what is being negotiated and I guess you could say at risk? Or you know, just being negotiated there?

Steven Schmidt

When we talk about the state contracts and the entire business here, again we have the largest market share in this space and we continue to grow share. What has happened from a revenue standpoint is as you know, just like everywhere else, state budgets are under pressure. As an example in the state of Florida they have been asked to reduce their budgets by 10%. California has similar tight requirements. So we’re working with each of the state contracts we have got to drive efficiency and effectiveness, to work with them on mix, to try to remix the contracts as best we can to improve the overall operating profitability of these businesses, but we will see continued price pressure from the standpoint of simply what is happening within this sector. So when you have a large share but again that is just something that is happening across the board with each of our major contracts.

We haven’t publicly disclosed the percent of our business that is in this sector of business. We have nineteen state contracts which we have talked about and it is a sector of business that continues to grow for us. So we’re going to continue to focus on this important area. We see this as being an opportunity for growth going forward and obviously we will deal with the issues we spoke about prior to hopefully make those go away over the near term.

Steve Chick

Thanks. Separately, if I could, maybe for Chuck. Going back to your comments on how the Easter shift effect on sales…am I…I just want to make sure I understand it correctly. The comp trend was down 7 and it came in down 9 for the quarter. Is that difference; is that kind of what you are attributing to the Easter shift? Is that safe to assume?

Chuck Rubin

You had an Easter shift and you had a shift in New Year’s. Both affected the shopping patterns. So what we said, Steve was that when you estimate those two that our trend was consistent.

Steve Chick

Okay. And as we look kind of going into the second quarter it is kind of a lower volume sales quarter for that division, so kind of to give back to Easter because of that shift, I guess technically should you have a little bit of a better benefit of the shift during the second quarter? Am I looking at that correctly?

Chuck Rubin

Unfortunately when we have gone back and looked at this in history the days don’t translate between times of year at the same volume level. So trading up a day in March is not the same as trading up for a day in April. So I think that we are viewing it more somewhat more conservatively.

Steve Chick

Okay. Thanks. Good quarter under the circumstances.

Operator

Thank you. I’m showing no further questions.

Steve Odland

Alright. Well we appreciate everybody’s attendance this morning and we look forward to talking with you in the future. Thanks very much. We’ll end the call.

Operator

Thank you. This concludes today’s conference. Thank you for participating. You may now disconnect.

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Source: Office Depot, Inc. F1Q08 (Qtr End 03/29/08) Earnings Call Transcript
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