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OfficeMax Incorporated (NYSE:OMX)

Q1 2008 Earnings Call

April 30, 2008 9:00 am ET

Executives

John Jennings – Senior Vice President, Treasurer, Investor Relations

Sam Duncan – Chairman, Chief Executive Officer

Sam Martin – Chief Operating Officer

Don Civgin – Chief Financial Officer

Analysts

Gary Balter – Credit Suisse

Mitch Kaiser – Piper Jaffray

Matthew Fassler – Goldman Sachs

Mike Baker – Deutsche Bank

Steve Chick – J.P. Morgan

Operator

Good morning, my name is Christie and I will be your conference facilitator for today. At this time I would like to welcome everyone to the OfficeMax first quarter 2008 earnings conference call. (Operator instructions) It is now my pleasure to introduce you to John Jennings, Senior Vice President, Treasurer and Investor Relations of OfficeMax Incorporated. Mr. Jennings, you may begin.

John Jennings

Good morning everyone and thanks for joining us today. I'm here with Sam Duncan, our Chairman and CEO, Sam Martin, our Chief Operating Officer and Don Civgin, our Chief Financial Officer. Before I turn the call over to Sam Duncan, I have a few administrative items. Today’s conference call will be archived on our web site for one year following the call. Note that this call may not be rebroadcast without prior written consent from OfficeMax.

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

Management believes that these forward-looking statements are reasonable, however the company cannot guarantee that it will successfully execute its turnaround plans or that its actual results will be consistent with the forward-looking statements and you should not place undue reliance on them. These statements are based on current expectations and speak only as of the date they are made.

The company undertakes no obligation to publicly update or revise any forward-looking statement whether as a result of future events, new information or otherwise. Important factors regarding the company which may cause results to differ from expectations are included in the company's annual report on form 10-K for the year ended December 29, 2007, under item 1A, risk factors.

As always after the call today, please feel free to call me with any follow up questions. It's now my pleasure to turn the call over to Sam Duncan, Chairman and CEO of OfficeMax.

Sam Duncan

Thanks John and good morning everyone. On today’s call I’ll review our first quarter 2008 performance. Then Sam Martin our Chief Operating Officer will detail our operating segment performance. And Don Civgin our Chief Financial Officer will review financial details and then we’ll take your questions.

For the first quarter of 2008, total sales declined 5.5% primarily reflecting the weaker US economy, our deliberate focus on profitable sales and the negative impact of the Easter holiday shifting to the first quarter of 2008 from the second quarter last year. Improved margins in our contract business offset by the deleveraging of costs in our retail segment resulted in operating income margin in the first quarter of 2008, decreasing to 3.4% from operating income margin of 4.5% in the first quarter last year.

Bottom line net income in the first quarter of 2008 increased to $63.3 million or $0.81 per diluted share. As we noted in our press release today, we had three unusual items not related to our core operating activities in the first quarter of 2008 that if excluded would increase operating income margin by 20 basis points and decrease net income by $9.8 million or $0.13 per diluted share.

Looking at our operating performance in the first quarter of 2008, there are two significant drivers, the US economy and our turnaround plan initiatives. We are pursuing actions near term to address the impact of current macroeconomic trends which we expect to continue throughout 2008. At the same time, we are continuing to implement specific turnaround initiatives which we believe will more solidly position us for long term improvement.

In US contract, our initiative to pursue more profitable new and renewing large accounts began even before we experienced the weaker US economy in the second half of 2007. A primary goal for our US contract business is to not chase unprofitable large accounts and to provide a foundation and an infrastructure to support better account predictability and performance.

And progress has been made as we focus on better customer account negotiations, leveraging our more efficient hunter and farmer sales teams and using better analytics to evaluate contracts. We also have more flexibility in our supply chain to adjust our delivery model and we have improved our product offering to match customer requirements.

Ultimately we believe we are creating win-win solutions with better service and lower costs for customers while delivering improved profitability for OfficeMax. Our progress with these initiatives is reflected in a 30 basis point improvement in our contract segment operating income margins for the first quarter, despite a 5.5% sales decline versus last year.

For our retail business, OfficeMax as with other retailers is obviously being impacted by weaker consumer and small business customers spending environment. However, we remain committed to addressing those aspects of our retail business that are manageable in a challenging economy.

We are implementing key retail initiatives which include rationalizing our promotional efforts, pursuing inventory efficiencies and our refined real estate strategy. Progress has been made and we are seeing some benefits from our efforts. Our more targeted and localized promotional activity contributed to improved point of sale gross margin rates in quarter one compared to the first quarter last year.

Efficient inventory purchasing, planning and fulfillment, however, resulted in 15% lower inventory per store versus last year, with the lowest levels of clearance inventory in four years. On our real estate, our first quarter 2008 retail results were impacted significantly by deleveraging costs for new and existing stores. New stores incur significantly higher costs and expenses as a percent of sales on a per store basis until they enter profitability, typically during the second year open.

Our first quarter 2008 retail operating income was reduced by about $10 million from the 77 stores opened during the past year due to occupancy and operating costs on lower sales. While our real estate investments have a negative impact in the near term, we believe these investments are prudent for long term improvement.

Our real estate strategy includes a balance of new store openings along with existing store remodels. Our new stores and remodels in 2008 and beyond are targeted in top priority markets where we also have existing stores and mostly where we already have a contract delivery presence.

In the first quarter we opened six new domestic stores and six new stores in Mexico to end the quarter at 988 total stores. We also completed 16 store remodels in Phoenix, Tucson and Denver. For 2008 we currently still plan to open a total of up to 40 new stores and to complete approximately 60 remodels in the US. Overall, we are working to enhance our operational performance across our business.

While we expect to continue to face macroeconomic challenges in 2008, we remain committed to implementing contract, retail and overall corporate initiatives to generate long term improvement. Now I’ll turn it over to Sam Martin to review the details of our contract and retail operating segments’ performance for the quarter.

Sam Martin

Thanks Sam. Good morning everyone. In our contract segment, while impacted by weaker US business spending trends in the first quarter of 2008, we remain steadfast in our more disciplined new large account generation and retention practices and experience and improvement in gross margin rates.

The result was contract operating income margin in the first quarter of 2008 increased to 5% which includes the 20 basis points impact from unusual items compared to operating income margin of 4.7% last year. Specifically for US contracts, which represented about 70% of total contract sales, first quarter sales declined 12.4% from the same period last year consistent with the trends we communicated last month on our investment day.

The sales performance for US contract primarily reflects four factors. First and most significantly was our disciplined focus on adding and retaining higher margin new large accounts. We added fewer accounts in the first quarter of this year compared to last year. And we were impacted by our decision not to retain one significant large US account which we terminated in mid-2007 because it was unprofitable to us.

Second, sales decreased from existing customers. Sales from accounts in place in the year ago period decreased by approximately 7% versus the first quarter last year, reflecting the softer business spending in the US. Third, lower small bucket customer sales which include sales from our public website and catalogue business, reflected the weaker US economy and our focus on profitability and related reduction in marketing investments.

And fourth, the Easter holiday weekend falling in the first quarter of 2008 rather than in the second quarter as it did last year, had a negative impact. We estimate that the Easter shift resulted in about 1% lower US contract sales in this year’s first quarter. During the first quarter of 2008, we continued pursuing our key sales priority of targeting sales from higher margin middle market customers.

Middle market sales remained a relatively small share of our total US sales, but we believe our expanded field sales representative team is dedicated to the middle market since mid-2007 and improvements planned for tele-sales productivity will lead to middle market account growth.

We are also making progress on our effort to grow ImPress Print & Document Services sales within our US contract account base. During the first quarter we implemented the restructuring of our ImPress organization for both retail, where we recorded ImPress sales and US contract. This included aligning ImPress field sales teams with our US contract field sales.

We are targeting incremental ImPress sales from our contract accounts, providing value added services to our customers. We are pleased with the contract gross margin in the first quarter, which increased to 22.7% from 22.1% last year. The improvement is attributed to improved negotiated account pricing from existing and new US customers. We improved large new customer account profitability from centralized pricing and controls initiatives implemented during last year.

While the number of new accounts decreased in the first quarter compared to last year, gross margin from these new accounts increased significantly. Contract bills gross margin improvement was partially offset by a lower of vendor income in the first quarter this year versus last year due to lower inventory purchases to manage lower sales and more efficient inventory management.

Our US contract gross margin in the first quarter of 2008 was also impacted by higher fuel rates and deleveraging fixed freight and occupancy costs as a percentage of sales. Fuel costs in the first quarter this year were up approximately 50% per gallon of diesel versus last year.

We were able to mostly offset these increased costs with efficiencies created through our most flexible delivery model, enabled with the US contract reorganization rollout last year. Our refined delivery model targets cost of service improvements, including optimizing delivery routes and allowed us to cut our total private fleet vehicles by 6% in quarter one compared to quarter one last year.

Contract operating expenses as a percent of sales in the first quarter of 2008 increased to 17.7% compared to last year with 20 basis points of the increase due to the unusual item related to the consolidation of manufacturing facilities in New Zealand. The remainder of the increase was due to deleveraging fixed expenses from lower sales. But this was mostly offset by targeted cost savings and lower incentive compensation costs.

Overall we are pleased with the progress our contract sales and operations leadership team have made in the first quarter to delivering operating income margin improvement. Turning to our retail segment, the first quarter was impacted by a weaker US economy as well as our pursuit of long term turnaround initiatives. Our first quarter 2008 retail sales declined as the impact of deleveraging both fixed cost of sales as well as operating costs.

The result was retail operating margin in the first quarter of 2008 decreased to 2.7% which includes the 20 basis points impact from an unusual item, compared to operating income margin of 5.5% last year. Our same store sales decreased 8.7% in the first quarter, primarily reflecting the weaker US economy and the Easter shift.

We estimate the Easter shift resulted in about 1% lower retail sales in this year’s first quarter as the Easter holiday fell in Q1 this year versus Q2 last year. However the most significant factor driving retail same store sales in Q1 is the US economy. It’s not surprise that OfficeMax was impacted by weaker consumer and small business spending.

Independent third party data indicates that the lower sales trend impacting many core electronics and furniture categories for OfficeMax are consistent with broader retail performance. We’ve been monitoring the impact of the weaker economy on retail sales and recently completed primary research on small business customers. The results of this study conducted during the first quarter of 2008 confirm customer concerns around the US economy are significant.

Most surveyed small businesses felt the economy is getting worse and 90% felt their finances had been impacted by current economic conditions. About two-thirds said they planned to cut back on their office supply spending for the next three to six months. And the types of office supply spending they are cutting, more than 60% surveyed indicated technology categories and about 50% indicated furniture categories.

So OfficeMax, while we experienced some same store sales declines across all our major categories, our first quarter sales were harder hit for technology and furniture than supply categories. In technology which represented 53% of our first quarter retail sales, we experienced double digit negative same store sales declines in business machines as well as PCs and laptops, that performed relatively well in Q1 last year due to the Microsoft Vista rollout.

One relatively strong technology subcategory for us in Q1 was ink and toner, which generated slightly positive same store sales, benefitting from targeted marking programs and enhanced in store presentations. Our furniture category which represented 9% of total Q1 retail sales experienced the largest same store sales decline, reflecting slower consumer and small business spending for these discretionary higher average ticket purchases.

Our supplies and paper category which includes ImPress represented about 38% of Q1 retail sales. Supplies and ImPress sales were impacted by lower customer traffic counts during the first quarter of 2008 as well as some significant ImPress promotional and advertising events in the first quarter of last year. This still outperformed technology and furniture in same store sales.

To manage sales performance in the weaker economic environment, we are continuously evaluating our merchandise offerings, marketing tactics and promotional strategy. Retail segment gross margin in the first quarter of 2008 decreased to 28.5% from 29.3% last year, due mostly to higher fixed occupancy costs and lower vendor income levels, partially offset by a sales mix shift.

Higher fixed cost and gross margin were due to deleveraging occupancy costs for new stores and our same store sales decline. Retail generated lower vendor income levels in the first quarter versus last year due to lower inventory purchases to manage the lower sales levels and more efficient inventory management.

The mix shift in the first quarter of 2008 was to a higher percentage of supply category sales at typically higher gross margin rates and a lower percentage of technology categories which typically carry lower gross margin rates. As a result of our more targeted promotional strategy and the mix shift, we improved point of sale gross margins with increases across all major product categories.

Retail operating expenses as a percent of sales increased in the first quarter of 2008 to 25.8% from last year. The 20 basis points of increase due to unusual items related to severance for the restructuring of our retail field and ImPress management organization. The remainder of the increase was due to deleveraging of fixed operating costs for new and existing stores, partially offset by reduced incentive compensation expense.

We are clearly operating in a challenging retail spending environment which has impacted our retail segment performance. As with our contract segment, we are focused on aspects of our retail business that we can control. We believe that significant opportunities remain for retail expense controls and our store management is benefitting from new leadership.

Taking a moment to update you on initiatives across both our contract and retail segments, we are continuing to pursue the strategies we discussed with you in March. This includes leveraging our consolidated supply chain to pursue optimization in contract delivery and retail store fulfillment.

In the first quarter of 2008, we completed the conversion to a single inventory forecasting system which has continued to improve our ability to forecast demand across our businesses. Our in-store stock metrics have improved even while we have reduced inventory per store. To offset the higher fuel costs across our businesses, we have also improved our truck cube utilization and we are driving fewer miles for retail store fulfillment.

Additionally, our improved delivery model is enabling reduced routes and trucks, reducing overall delivery miles for contract. In merchandising we are utilizing our customer research to develop appropriate product offerings. We expect that some of these product offerings will be in our stores and available for delivery during the second half of 2008. The new products are not expected to expand total item counts, but combined with item rationalization across contract and retail for both branded and private label merchandise.

Private label sales in the first quarter of 2008 represented 26% of total sales, up from 23% in total in the first quarter last year. And we believe there are further opportunities to penetrate many key categories, especially through increased foreign direct coursing and importing.

While we monitor economic weakness in the US, we remain committed to addressing opportunities for improvement within our operating segments. As you’ve been hearing from us consistently, we believe that solid execution of our turnaround plan and initiatives will enable long term improvement for OfficeMax. At this point I’d like to turn the call over to Don Civgin so he can review financial details for the first quarter of 2008.

Don Civgin

Thank you Sam and good morning everyone. Let me start with a review of the P&L. For the first quarter of 2008, net income was $63.3 million or $0.81 per diluted share compared with net income of $58.5 million or $0.76 per diluted share for the same period last year. Results for the first quarter 2008 and 2007 includes some unusual items not related to our core operating activities that we want to discuss.

In the first quarter of 2008 three unusual items improved income by $16.3 million before taxes and $9.8 million after taxes or $0.13 per diluted share. I’ll provide some more specific details of these unusual items as we go through the P&L. Consolidated net income for the first quarter of 2008 decreased by 5.5% to $2.3 billion from $2.44 billion in the first quarter of 2007.

Contract segment sales in the first quarter of 2008 decreased by 5.5% to $1.2 billion compared to the first quarter of 2007 reflecting a 12.4% sales decline in US contract and a 14.7% sales increase from international contract operations. In local currencies, international contract sales decreased by 0.9% in the first quarter.

Retail segment sales decreased by 5.5% in the first quarter of 2008 to $1.11 billion compared to the first quarter of 2007. Gross margin in the first quarter of 2008 was 25.5%, down 10 basis points from the first quarter last year reflecting higher contract segment gross margins, offset by lower retail segment gross margins.

Contract segment gross margins for the first quarter was 22.7%, up 60 basis points and retail segment gross margins for the first quarter was 28.5%, down 80 basis points from the same period last year. Operating expense for the first quarter of 2008 increased to 22.1% of sales, up 100 basis points from the same period last year.

The increase in operating expense in the first quarter of 2008 includes two unusual items totaling $4.2 million or 0.2% of sales. One item is related to a $2.4 million expense recorded in our contract segment for the consolidation of manufacturing facilities in our New Zealand operations. The other item is a $1.8 million expense recorded in our retail segment related to employee severance for restructuring our retails field and ImPress management organization.

Contract and retail segment operating expense increased as a percentage of sales, while we reduced corporate and other segment expense. Our corporate and other segment expense for the first quarter of 2008 decreased by $4 million to $10.4 million compared to the first quarter of 2007.

Corporate and other segment expense in the first quarter of 2008 benefitted from a combination of lower incentive compensation costs and lower legacy company costs, along with a variety of targeted cost savings compared to the same period last year. The other unusual item that we recorded in the first quarter of 2008 was income before taxes of $20.5 million related to our investment in Boise Cascade LLC.

Recorded as other income on our P&L, this income from Boise Cascade LLC is primarily related to their sale of a majority interest in their paper, packaging and newsprint business that they completed during the first quarter of 2008. Our investment in Boise Cascade LLC remained on our balance sheet as an investment and affiliate of $175 million.

Our effective tax rate in the first quarter of 2008 decreased to 29.8% from 39% in the first quarter of last year, benefiting from the resolution of certain tax matters, including the release of some tax reserves from the settlement of tax audits.

Moving to the balance sheet, we ended the first quarter 2008 with inventory of $33.7 million lower than at the end of the first quarter 2007. The decrease is primarily related to lower inventory per location in both retail and US contract, partially offset by store growth and an increase in international contract inventory mostly due to foreign currency exchange rates.

Inventory per store decreased by approximately 15% at the end of Q1 2008 compared to the same period last year, benefitting from supply chain and inventory management initiatives. Inventory turns decreased to 6.4 times in the first quarter of 2008 from 6.7 times in the same period last year, primarily due to lower turns from new stores as they ramp up productivity.

Accounts payable at the end of the first quarter of 2008 were $9.6 million lower than the same period last year, primarily reflecting the timing of vendor payments and lower inventory levels. Accounts receivable at the end of the first quarter of 2008 were $123.8 million higher than the same period last year, primarily as a result of terminating our accounts receivable securitization program on July 12, 2007, with the simultaneous restructuring of a revolving credit facility.

By amending and restating our revolver, we expect improved financing terms and lower total cost. At the end of the first quarter of 2008, under our amended $700 million revolver, we had $582 million available reflecting our available borrowing base of $652.6 million, no borrowings and $70.5 million of letters of credit issued under the revolver.

At the end of the first quarter of 2008, we had total debt excluding the timber securitization notes of $368.3 million and cash and cash equivalents of $211.4 million. We calculate total debt excluding the $1.47 billion of timber securitization notes, since recourse on the notes is limited to $1.635 billion of timber installment notes receivable.

Turning to cash flow, during the first quarter of 2008 we generated $142.4 million of cash from operations, an increase of $223.3 million from the first quarter of 2007, primarily due to improved inventory and accounts payables levels. Capital expenditures totaled $33.8 million for the first quarter of 2008 and we expect capital expenditures for the full year 2008 to total between $200 and $220 million.

I’ll now turn the call back over to Sam.

Sam Duncan

Thank you Don. Building on the progress we made in the first quarter of 2008, we are continuing to execute our turnaround plans. We are specifically focusing on streamlining the organization to leverage our complimentary contract and retail business models, driving differentiation in merchandising and marketing, continuing to improve our supply train and infrastructure and building a foundation for long term shareholder value generation.

We anticipate continuing to operating in a challenging consumer and business spending environment and the year over year sales declines in April 2008 for contract and retail continued to trend at similar levels in the first quarter of 2008. As we manage our business in this environment, we expect to pursue margin and cost management initiatives that will position OfficeMax to navigate through near term challenges while allowing us to maximize long term opportunities.

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

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Gary Balter – Credit Suisse.

Gary Balter – Credit Suisse

I have a longer term strategic question and in advance of that I’ll say that from our side as we look at it, I think you’ve done a great job in terms of dealing with the current, what’s going on from a macro point of view, making the investments back into the systems etc.

In that context though, as you look at your market share and you look at where you’re positioned, has there been some thought about, especially given that there may be a consolidation of the contract side and you’ll face a tougher competitor going forward, has there been though about should we be more aggressive on pricing?

Should we give up some margin right here to try to gain market share in a difficult environment as we fix up our systems and fix up our infrastructure. Because coming out of it, if we have too little market share we’re not going to be well positioned regardless. What’s your thinking about short term versus longer term?

Don Civgin

Before Sam answers that let me just say that John mentioned at the beginning of my prepared comments, I may have said that inadvertently that net income was $2.3 billion instead of net sales, so just as a clarification if that was the case, I want to make sure everyone realizes it was net sales that was $2.3 billion and not net income.

Sam Duncan

Gary in response to your question, we’ve said all along that we’re not going to give away the farm. We’re going to pursue profitable business. And it’s even more important when you get into the current macroeconomic environment that we’re in today, you can’t go out there and start chasing sales, either in retail and contract because what they’ve seen in the past is you just make matters worse by your expenses going up due to marketing efforts or whatever.

We’re going to stick to our strategic brand of continuing to focus on profitable sales. We believe in the long term that is the best avenue for us and we remain committed to it.

Gary Balter – Credit Suisse

But how do you measure that against competitor pressures that are going to stay out there? Like you mentioned yourself it’s going to be a tough economy for 08, probably that continues into 09. There’s a level, you’re making all these very strong investments back into the core. But will you ever get rewarded for that if you don’t have the top line?

Sam Duncan

Well we think so over time and we think if we remain committed to what we’re focused on, we will get the improvement over time. And we’re going to remain committed to it and I’ll let Don make a comment on that.

Don Civgin

Gary let me throw out one other thing. I think if you look at the way our contract business operates today as opposed to when we started this turnaround, we’re actually able to take more business in a profitable way than we were able to do before, simply because of the discipline we have on the cost to serve side and understanding the dynamics of pricing and all of that for ourselves.

So I think part of this is, you can’t just go chase the sales before you’re ready for it and I think we continue to position ourselves to be able to get more sales that may be previously wouldn’t have been profitable, but in the future are. So you know it’s not a toggle switch where you just say now I want sales, you have to position yourself to be able to do something with that sales and like it when you get it.

Gary Balter – Credit Suisse

Same thinking in retail?

Sam Duncan

Well retail, it’s a bigger function of the macroeconomic environment. You know in our industry we’re the first wave that’s going to see the economic impact. People don’t need to buy a fax or a printer right away, they can put that off and that’s what we’re seeing. And with that being said, we could easily go out there and dump all of this money and marketing and not get an ounce of sales out of it.

And again I’ve seen that happen in the retail business and we’re just not going to do that. We’re going to be very strategic in what we do on our retail side also. And we’ve got to remain focused on what we’re doing and when this macroeconomic environment improves, you know hopefully we’re going to be a lot better off. And that’s what we feel today.

Operator

Your next question comes from Mitch Kaiser – Piper Jaffray.

Mitch Kaiser – Piper Jaffray

I was hoping, just to extend on Gary’s question a little bit, certainly you’re not going to chase unprofitable sales on the contract side, you’re making some investments in systems, but where do you think you stand in terms of some more cost take out. And at what point do you feel the core is ready to start going after some bigger contracts etc.?

Sam Martin

I would say that we have not stopped going after the right sales. And our core in terms of cost reduction is a real equation of the economy and the amount of business that we can garner. There are business gains we get every day as well as some businesses we do forego because of the price that we would need to pay. So as a longer term point of view, we continue to go after the sales that we can make profitable for our company. And there are sales out there to get.

Mitch Kaiser – Piper Jaffray

You mentioned retail, the comps trending to more of the Q4 and Q1, I was hoping you could comment on how we should be thinking about sales on the contract business?

Sam Duncan

The only thing we’ll say is that we don’t see the current macroeconomic conditions improving, as we said, in 2008. We’re not economists but that’s our feelings and from what we see and hear from our customers, we think 2008 is going to be, we’re going to continue to face these macroeconomic conditions, but hopefully it will improve after that.

Mitch Kaiser – Piper Jaffray

I was hoping you could comment on market share in technology. Kind of hear mixed messages, not from you but rather, hearing some of your competitors talking about weakness in technology but then some of the consumer electronics retailers talking about strength here. Are you seeing anything in the data on the market share that there’s a shift between channels or how would you categorize just where sales are trending on the technology set?

Sam Martin

We primarily look at our sales and look at what we are able to analyze over the course of time. But the shift in technology sales for us has really been related to a couple of things: one, the economy in terms of people being able to forego purchases, and second, the comparison to a year prior’s launch of Vista and the product bumps that we received during that launch time.

Mitch Kaiser – Piper Jaffray

And are you seeing a shift when you look at the market share data, are you seeing the consumer electronics retailers taking share? Is that your perspective or not?

Sam Martin

I haven’t seen that in my perspective.

Operator

Your next question comes from Matthew Fassler – Goldman Sachs.

Matthew Fassler – Goldman Sachs

I want to start by focusing on the retail business. If I look at you and I compare you to your competitors, it seems like your same store gross profit trends are holding up relatively better. Your comps were under pressure but your merchandise margins, from what you said, are up. And that most of the margin decline relates to deleverage on fixed costs.

So I guess my question is, how aggressive have you been on reducing variable costs. You talk about investing for the future, I’m not sure if that includes holding labor levels and how variable you have viewed your cost structure in retail as being here.

Sam Martin

As we look at the retail cost structures, we keep in mind the relative comparison to sales and understand that we need to have a certain level of staffing in our stores to be able to satisfy our customer’s shopping experience. So it’s not, it’s a complicated equation so to speak but it’s a simple expectation that we meet our customer’s needs and we don’t cut below the level of staffing if you will to sacrifice that. But at the same time we do have to keep a close eye on the relationship of labor with regards to the sales trends.

Matthew Fassler – Goldman Sachs

How deeply have you cut relative to potential, would you say you’re at the bone, is there more room to go if sales remain under pressure?

Sam Martin

I think as you look creatively at what you have in your cost to deliver business, in our industry, we have to find ways to be more efficient in what we do. So it’s not just one component of store labor or any other single component, but an overall way, the number of things that we do to drive our sales, we look at every area of cost to contain it and control it.

Sam Duncan

Also, we still have opportunities in our supply chain which we’ve said all along. And you look at what that has done for us this year, I am incredibly happy and pleased with our store inventories levels being down 15% from last year and our clearance inventories being the lowest level in four years. Those two things add up to improved gross margins.

And as we continue to work on our supply chain initiatives, which Rubin Sloan and his team have done a phenomenal job, you know hopefully we will see some improvements there. But we still have some room for improvement and our supply chain and our people are aggressively working on it.

Matthew Fassler – Goldman Sachs

My next question relates to the contract sales decline in the US, that 12% hit, can you try to disaggregate that I guess first of all by customer size, you know the medium size business, is that up or down. Small, medium customer business, is that up or down versus the large customer business? And at what point do we start to cycle some of the separations you have with customers a year ago which I guess is having some disproportionate impact on the sales numbers.

Sam Duncan

On our contract business we do some 80% of our business in the large customer segment is what we call it. And in that segment is where last year we exited a contract from a very, very large customer because it wasn’t profitable and we should start I believe, we are cycling that the second half of the year. But John Jennings can chart that and get back with you to verify that, but I’m pretty sure that’s the case.

You know we will continue to review accounts. There’s been more than one account that we walked away from because the gross margin being negative or the total economic value added of the account being negative and we will continue to look at those. In the long run we feel it’s the right thing to do.

Matthew Fassler – Goldman Sachs

If you look at vendor income, you spoke about reduced vendor dollars coming into play to some small degree in the first quarter, how much longer are the vendor dollar comparisons difficult such that if the sales environment stays where it is, that will be a drag on the numbers year to year?

Don Civgin

I think that question is impossible to answer because it depends on what receipts are. So I mean it’s going to depend really on what happens to the top line. Our commitment is going to be to do the best job we can managing the inventory and if that means vendor inventory is going to suffer, it may be a short term pain but in the long run that’s the right thing to do.

Matthew Fassler – Goldman Sachs

Finally, you’re having these onetime items, I guess related to paper prices vis-à-vis Boise that we don’t factor into continuing earnings, but they have resulted in some pretty significant off the run earnings for you over the past couple of years. What would it take for those to work against you?

You know clearly The Street doesn’t factor those into earnings but there’s some rough transfer to OfficeMax right now and I guess theoretically could go the other way. What would the circumstances be and is there any scenario in which that could be meaningful for cash or any other perspective?

Don Civgin

Are you talking about paper prices or are you talking about the unusual item that we talked about?

Matthew Fassler – Goldman Sachs

I guess I’m talking about both, if you could give us clarity on the unusual item if that’s not what it really related to, that’s probably my misunderstanding then.

Don Civgin

Well the unusual item that we talked about, the $20.5 million is related to the transaction that sold the paper product business first quarter and so we received a distribution of $20.5 million during the quarter in other income. That’s not something that you can predict when it’s going to happen, what it’s going to look like and whether it helps you and so forth. That I don’t know that it has any bearing on what happens in the future or what’s happened in the past.

Matthew Fassler – Goldman Sachs

Did that impact by the way the book value of the Boise LLC?

Don Civgin

No.

Matthew Fassler – Goldman Sachs

So book value stays where it was, that was just a cash distribution to you?

Don Civgin

Yes.

Sam Duncan

Just on a paper pricing, I will make a comment that three years ago when I came to the company, paper pricing on a per ton basis was somewhere between $700-$800 a ton. Today it’s well over $1,000 a ton. A lot of that is due to the dollar being so low, very little imports coming in. So will that drop in the future, don’t know, but we sure hope so.

Don Civgin

Let me just also say, just to close it off completely, with respect to what happened in the fourth quarter with the additional consideration agreement being terminated, that agreement is now closed. So anything that we had seen in the past relating to unusual income or expenses or anything like that, because we don’t have that agreement going forward, that we would not expect to see again.

Matthew Fassler – Goldman Sachs

And that had been tied to paper prices?

Don Civgin

Yes.

Matthew Fassler – Goldman Sachs

So that complicated addendum to your Q’s etc, that is now done?

Don Civgin

Yeah, I mean we’re still subject to the market price of our raw materials and the products we sell, but the additional consideration agreement has been terminated.

Operator

Your last question comes from Mike Baker – Deutsche Bank.

Mike Baker – Deutsche Bank

Two questions, one, in the retail business was a pretty big swing in gross margin trends relative to the fourth quarter, I understand that deleverage in the occupancy but your comps were pretty similar with what they were in the fourth quarter, so does that mean you’re not seeing as big of a mix benefit as you saw in the fourth quarter? That’s question one.

Question two is just, following on Matt’s question, I don’t know if you specifically addressed it, I think you had said in your comments, small market sales were down, how about middle market and as a general idea, that has been a big push for you guys a few years ago and it hasn’t seemed to work, now you’re pulling back on the promotional activity there. Is that initiative maybe less of a focus in this environment than it was?

Sam Martin

I would say that the middle market and smaller market customer segmentation is still a focus of ours. And we talk to the large accounts, some of the similar dynamics affect the middle market accounts as well at some levels. But our initiatives are still targeting those middle market customers and we are obviously looking for more and different initiatives but the US macroeconomic conditions are the major impact, has a major impact on customers as well.

Mike Baker – Deutsche Bank

Do you have any way of knowing if you’re gaining or losing or maintaining share there in that segment?

Sam Martin

No.

Mike Baker – Deutsche Bank

Secondly on the gross margin trends?

Don Civgin

I think on the margins, it’s a little difficult to look with fourth quarter and first quarter sequentially because the revenue levels are so different. We also opened a lot of stores during the fourth quarter which raised particularly on the lower volume in the first quarter, raises the deleveraging impact.

And frankly I think the excellent inventory management we’ve had has hurt us on the volume threshold as well. So I don’t think it’s a surprising result given some of the big drivers that I’ve just mentioned.

Mike Baker – Deutsche Bank

So it sounds like the clear trend is more indicative of what we might see over the next couple quarters assuming that sales don’t get materially better, is that fair to say?

Don Civgin

I don’t know, I mean there’s a lot of things that come into play from quarter to quarter and I don’t want to go into what might happen in the second quarter or the third quarter, but you know it is what it is, it depends on what your receipts are because your programs typically don’t change that much.

Operator

Your next question comes from Steve Chick – J.P. Morgan.

Steve Chick – J.P. Morgan

A couple questions, I guess Don we talked a little bit about this at your analyst conference, given the deleverage that you’re seeing in retail and it doesn’t sound like sales are going to improve anytime soon, you know the average life left on your leases is relatively short as I look at you guys versus other retailers.

And I’m wondering if you’re open minded about or maybe why you’re not looking at things more aggressively in terms of letting more leases expire and maybe taking a little bit more of a defensive posture with real estate, maybe as it relates to net closures or relocations. Can you speak to that a little bit?

Don Civgin

Sure, listen every time we have a real estate decision to make we look at the fundamentals and make it on the basis of what we expect the longer term value to be. What I don’t want to do and none of us want to do is react to an economic cycle and make decisions that three years from now we’ll wish we hadn’t made.

So we look at the somewhat longer term implications of opening store, closing a store, remodeling a store and whatever those decisions are and try to make them prudently in the context of how much cash we have available and what we want our credit spending to look like.

So I think we do exactly that. And I think we have taken a defensive posture where we think keeping a store open poses a risk to us. But where we think it’s an opportunity, actually I would say we would be aggressive and take advantage of that opportunity so that when the cycle does come back, we’re not disadvantaged and we’re actually in a strong position vis-à-vis real estate than we were when we entered.

Sam Duncan

We have a real estate committee and in those committee meetings we look at every store where the lease expires and we decide if we want to renew that lease or not and we look at all the financial metrics to help us make that decision. So we are constantly looking at that throughout the year when leases expire. So it’s something that we focus on all the time.

Steve Chick – J.P. Morgan

And the targeted 40 new store openings for the year, can you clarify if that is both the US and Mexico or is it just US? And then related to that, Don, the $200-$220 million cap ex guidance looks pretty high given what you spent in the first quarter and it looks like maybe how the store openings will weight out. But are you still pretty comfortable that’s the level you might spend or does that have some kind of wiggle room in terms of maybe being south of that level of spend?

Sam Duncan

First of all, the 40 stores are in the US. And those are stores where we probably signed the lease well over a year ago. You’re usually working anywhere from a year to two years in advance. But all of those stores are in the US and I’ll let Don make a comment on the cap ex.

Don Civgin

With respect to the $200-$220 in cap ex, look we look at that constantly and where we have opportunities to pare back and be a little bit more prudent with our capital, we do that. But I think as we sit here today, the fact that we’ve spent less than 25% of that in the first quarter doesn’t lead me to think that that’s not still a realistic number for us. So I think it’s a good working assumption. But if we have opportunities to cut it back, where we find investments that don’t pan out when we look at the actual numbers, we’ll do that.

Steve Chick – J.P. Morgan

And last two if I could, related to the tax rate for the quarter, Don did you quantify what those items were, how much it was for the quarter, I think the reversals or the tax items that you mentioned. And then what type of rate should we kind of use I guess for the year?

Don Civgin

I did not, I’m happy though to Steve. The reversal was about $8.5 million which was obviously the predominant reason that the rate was what it was compared to either last year or what we would expect on a going forward trend. So I think the rate we’ve talked about in the past, which is in the upper 30’s is a reasonable run rate for us given the mix of international activities we have an so forth. So it was an unusually low quarter from a tax rate.

Steve Chick – J.P. Morgan

And then lastly, just in terms of contract delivery segment, sales down 5.5% for the quarter and I guess without Easter it sounds like that would have been down 4.5%. At your analyst conference I think you said that with international that you’re expecting or trends were low single digit declines. So it seems like maybe the decline got a little worse towards the quarter end. Can you clarify that? Was that the type of trend line that you had expected or did it worsen as the quarter went on?

Don Civgin

I don’t remember exactly what we said at the investor day. But I think the answer is it was about what we expected and I wouldn’t say it was materially different than what we were seeing in the first half of the quarter.

Operator

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

Sam Duncan

Thanks for joining us today.

Operator

This does conclude today’s conference call, you may now disconnect.

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Source: OfficeMax Incorporated Q1 2008 Earnings Call Transcript
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