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Executives

Brian Turcotte - Investor Relations

Steve Odland - Chairman of the Board, Chief Executive Officer

Carl Rubin - President, North American Retail

Steven M. Schmidt - President, North American Business Solutions

Charles E. Brown - Acting Chief Financial Officer; President- International

Analysts

Matt Fassler - Goldman Sachs

Kate McShane - Citigroup

Chris Horvers - JP Morgan

Michael Baker - Deutsche Bank

Colin McGranahan - Sanford C. Bernstein

Daniel T. Binder - Jeffries & Company

Analyst for Gary Balter - Credit Suisse

Office Depot, Inc. (ODP) F2Q08 Earnings Call July 30, 2008 9:00 AM ET

Operator

Good morning and welcome to the second quarter 2008 earnings conference call. (Operator Instructions) I would like to introduce Mr. Brian Turcotte, Vice President of Investor Relations, who will make a few opening comments. Mr. Turcotte, you may begin.

Brian Turcotte

Thank you, Melissa. 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 and thank you for joining us for Office Depot's second quarter 2008 conference call. With me today are Charlie Brown, President of International and Acting CFO; Chuck Rubin, President of North American Retail; Steve Schmidt, President of North American Business Solutions division; and of course, Brian Turcotte from Investor Relations.

The press release and accompanying webcast slides for today’s call are available on our website at www.officedepot.com. Click on company information, and then investor relations.

During our first quarter earnings call in April, we provided a second quarter outlook for the company that included sluggish sales and a 200 to 250 basis point decrease in EBIT margin from the previous year’s level of 4.7%. The international and North American business solutions divisional performance was close to our original expectations. However, as we noted in our press release three weeks ago, Office Depot continued to be negatively impacted by the challenging economic environment in the second quarter of 2008 and we estimated that our EBIT margin could fall an additional 200 basis points. While our actual EBIT was within that revised outlook, most of the shortfall versus the original expectations was experienced in the North American retail division.

Sales were below expectations, particularly late in the quarter and our product margins were also below expectations, and our fixed costs were significantly deleveraged. We experienced higher-than-expected shrink charges following our annual physical counts in the quarter. In the corporate area, we recognized severance costs from a late quarter staff reduction and legal and professional expenses related to our proxy contest and regulatory matters.

Second quarter 2008 total company sales were $3.6 billion, a decrease of 1% compared to the second quarter results last year. The net loss on a GAAP basis was $2 million compared to earnings of $106 million in the second quarter 2007. The GAAP loss per share on a diluted basis was $0.01 for the quarter versus diluted earnings per share of $0.38 versus year-ago, but the as-adjusted diluted earnings per share for the second quarter were $0.04 versus $0.41 in the same period last year.

Total company operating expenses as adjusted represented 26.9% of sales, an increase of 110 basis points over the second quarter of 2007. EBIT as adjusted was $21 million in the second quarter, or 0.6% as expressed as a percentage of sales, compared to $170 million or 4.7% in the same period last year.

The division presidents will walk you through their action plans to improve the performance in each of our three businesses. I’d like to set the stage by telling you that the management team and associates at Office Depot will continue to do everything we can to profitably growth the top line, cut costs, reduce our CapEx, and improve cash flow. For example, to profitably grow our top line, we’re expanding entry level price points for core business essentials in North American retail as well as rolling out tech services nationally, bundling newly expanded services with our products and aggressively growing Worklife Rewards sign-ups.

We are increasing our focus on direct marketing in the business solutions division, particularly in the catalog area, and implementing our customer contact strategy. In international, we’re focusing on our marketing strategies on retaining and expanding existing customers in the U.K., and we’re rolling out Tech Depot and our design print and ship services there.

To cut costs and reduce CapEx, we’re reducing the number of anticipated store openings to less than 15 stores this year and remodels to eight for the balance of the year in North American retail. That’s less than 15 stores left for the year. We’re conducting line reviews with our vendors and we initiated a voluntary exit incentive program for certain employees.

To improve cash flow, we’re working to reduce our working capital through reduction in our global inventory and our receivables level.

Now I’ll turn the call over to Chuck Rubin to talk about North American retail.

Carl Rubin

Thanks, Steve. Second quarter sales in the North American retail division were down 6% to $1.4 billion. Comparable store sales in the 1,178 stores in the U.S. and Canada that have been open for more than one year decreased 10% for the second quarter. We experienced sales declines in our major product categories of furniture, supplies, and technology. Sales slowed noticeably at the end of the second quarter but comp sales trends have improved slightly thus far in July.

Similar to what we have reported over the last couple of quarters, we continue to be negatively impacted by weakening business conditions in North America, specifically weakness in Florida and California continue to weigh heavily on our results; however, their impact to our sales has remained consistent to what we have reported over the past two quarters after worsening the previous six quarters.

Outside of those two states, we have experienced a further decline in demand as this economic slowdown has spread throughout other regions of the country. All of the decline, according to a third party [economic metric] modeling, is due to macroeconomic factors. While most of the sales decline was measured by a reduction in the number of transactions, average order value also was down slightly versus the same period one year ago.

In the second quarter we opened six new stores, closed one, and relocated three, bringing our total store count to 1,272. We also remodeled two stores, bringing the total for the first half of the year to three stores.

We are pleased with the continued progress made with our service levels. Mystery shop scores were 96% in the second quarter. That’s up nearly 4% versus last year and our in-stock service rate in our top 200 selling SKUs was over 99%.

The operating loss in the North American retail division was $4 million for the second quarter of 2008, a decline from record second quarter operating profit margins of 6.5% in the same period of the prior year. We’re very disappointed with the operating margin results, which were driven by deleveraging from lower than expected comps and gross margins.

With lower sales levels versus year ago, fixed cost and operating expenses deleveraging reduced margins by approximately 290 basis points compared to last year. The operating expenses impact was driven primarily by deleveraging of payroll as we reached a base level of staffing in the second quarter, traditionally our lowest volume quarter, that is required to maintain our customers’ expected service levels. On an actual dollar basis, SG&A was flat versus last year, despite additional costs related to an additional 86 stores opened since the last year.

Product margins were approximately 220 basis points of the decline. As we previously communicated, lower vendor program support was expected due to lower sales volumes discussed in previous earnings calls. However, vendor program support was also lower due to a shift in mix of product sales and a continued tightening of support from vendors. Additionally, we conducted [clearancing] to mitigate inventory risk, which was partially offset by private brand and better promotional management. And finally, inventory shrink lowered our margins by 170 basis points.

Let me outline the actions to improve our operating margins going forward. First, we’re accelerating our product assortment reviews to reduce our overall SKU count to ensure the lowest possible costs and thereby improve margins. We expect to have a significant portion of these completed by the end of this year. Since June, for example, we’ve completed nine line reviews resulting in significant cost savings on our future purchases, which will certainly improve our future margins.

Secondly, we are micro assorting our key technology departments to better match our offering to the individual store sales volume and customer profile. We believe that this action will lower end of quarter clearancing activities.

Third, we are implementing stringent inventory controls to support more conservative sales forecasts, which are roughly comparable to what we have seen year-to-date. This should reduce end-of-life clearancing and improve margins and cash flow.

Fourth, we’re significantly reducing our new store opening plans. While we still believe in the long-term prospects for growing our real estate footprint, we will open less than 15 new stores for the balance of this year and a total of about 45 stores in 2009. These are committed leases, which would cost more to break than to actually open the stores.

Fifth, we’re slowing our remodeling efforts. For the balance of the year, we anticipate remodeling eight more stores and they will be landlord funded. Like opening new stores, we believe in our M2 format and our goal remains to have most of our North American retail stores in the new format at the earliest possible date. However, we need to control our expenses can capital spending during these challenging economic times and we will be taking a more conservative approach to remodeling stores.

And sixth, we will continue to manage our costs. As a result, we are reducing our North American retail headcount based in our corporate office. This reduction is through increased efficiencies and will not impact our commitment to the high service levels we have in our retail stores.

I’ll now address that Taking Care of Business key actions to improve our sales going forward. We will address our customers’ increasing need for low prices and high value by focusing on expanding our entry level price points for core business essentials, partnering with our key vendors to secure opportunistic one-time purchases that deliver exceptional value, offering bonus packs that provide additional product for the customer for little to no additional spend, providing product and service bundles that offer a complete solution to the customer while also saving them money and continuing to focus on maximizing our high traffic promotional space by utilizing the stronger merchandise impact and selling higher value products.

In addition, for bigger ticket purchases we will offer extended financing through our banking partners. We will also continue to aggressively target our Worklife Rewards loyalty members. These valuable customers shop more often and spend more money with us the non-Worklife Reward customers and have higher margins.

During the second quarter, we continued to grow our membership by 25% versus a year ago. For the balance of this year, we will increase our targeted advertising to these members with unique offers and special pricing and we will also continue to focus on increasing our membership base.

We will expand our portfolio of services to fulfill the unmet needs of micro business customers. To date, we are very pleased with the performance of our tech services offering and expect to roll it out to all stores nationally during the third quarter.

This in-store or on-site technology service ensures technology products are properly set up and addresses the customers’ needs. In addition, our design, print, and ship offering will expand our capabilities and customer solutions through vendor partnerships and infrastructure investments.

And finally, we expect to expand our other service offerings, including tech recycling, a small business leasing option for technology, furniture, and services, and identity theft protection to round out our service offering to the micro business customer. All of these offerings have higher-than-average margins.

As we look to the balance of the year, we see continued sales challenges, although our very early third quarter sales show slight improvements. We remain committed to our customers and believe offering them great value in our products and services, along with a friendly helpful store environment is critical. We believe the plans have outlined along with the historically higher revenue levels of the third and fourth quarters will return the North American retail business to profitability.

Now I would like to turn the call over to Steve Schmidt.

Steven M. Schmidt

Thanks, Chuck. Total sales in North American business solutions division were nearly $1.1 billion, down 5% versus the same quarter of last year. Despite low-single-digit sales growth with our large national account customers and in the public sector, a 10% sale of decline to small to medium-sized customers resulted in a 5% decrease in contract sales. Additionally, sales in our direct business declined 6% year over year. However, the performance of this business has improved and is beginning to show signs of recovery.

Business solutions business in Florida and California, which accounted for about 30% of the division’s sales in the quarter, continued to be soft among small to medium sized customers. In the second quarter, these two states were down 6%, making up nearly 40% of the division’s total sales decrease versus the same period last year.

Outside of these two states, we have also seen a deterioration of business conditions. Almost half of the decrease in division sales were related to Tech Depot, our technology business, which resulted in part from our purposefully eliminating unprofitable accounts in this business. Unfortunately, we’ve not yet seen the flow-through in margins due to the continued softness of the small to medium-sized businesses that tend to deliver higher margins.

The North American business solutions division had an operating profit of $49 million for the second quarter 2008 compared to $78 million for the same period in the prior year. The operating margin decreased from 7% in 2007 to 4.6% in the second quarter of 2008. Our margin was about 60 basis points lower than expected due to lower sales and customer mix.

The key components of the operating margin decline versus year ago include the following key factors: approximately 160 basis points of this decline related to product margin, including a change in customer mix, increased promotion activity, and some cost increases that could not be fully passed along to our customers. Additionally, we experienced a decrease in vendor program support which reduced operating margin by approximately 40 basis points. Other negative impacts to operating margin included a deleveraging of fixed cost against lower sales levels, totaled approximately 70 basis points. And offsetting these negative factors, operating expenses as a percent of sales decreased approximately 30 basis points from the second quarter of 2007.

Before I update you on our action plans in North American business solutions, I’ll review the status of our state contract businesses. Office Depot currently has state contracts in 21 states in the U.S., and in many cases we have very longstanding relationships. The State of Georgia is one example where we have had a long business relationship for over the past 20 years. A great deal has been written about this issue, so let me clarify a few points.

Since 1998, Office Depot has successfully served hundreds of state and local customers in Georgia, selling millions of products to satisfied customers. In 2006, the State of Georgia decided to go to a single source statewide contract. Office Depot won the competitive bid for the statewide contract, which commended in March of ’07. While we believe that our performance under the contract was very good, the state elected to terminate our contract for convenience, a decision which we strongly disagreed based on our performance. Office Depot is not suspended or otherwise precluded from selling to customers in Georgia. Although Office Depot is not participating in the current bid, we will continue to offer superior products and services to any state and local agency until a new contract is awarded, and thereafter to numerous local agencies that are not required to use the statewide contract. However, we do have annual sales impact of approximately $20 million.

Turning to our Taking Care of Business action plans: first, we have completed the pilot test of our behavior based customer contact strategy and have rolled out the tools and processes of this plan to the entire BSD field organization. To date, we are very encouraged with the results and expect it to have a positive impact our performance in the third quarter of this year.

Second, although our outbound selling telephone account management, or TAM organization continues to improve, it is still not meeting our expectations. We will continue to work very closely with the two third-party firms who handle this business by instituting key performance indicators, new hiring standards and marketing programs, as well as improved call processes. As I mentioned last quarter, a third-party firm hired some of our best former sales representatives and preliminary results remain encouraging, with their revenue performance outpacing the results of our other TAM representatives. We feel that all of these changes will significantly upgrade the entire TAM organization.

Third, our direct marketing team has made considerable progress during the quarter. We significantly increased our focus on this area, particularly in catalogs, and the results are beginning to pay off. Additionally, our customer file, which is a measure of our unique customers who have purchased from us in the past year, grew for the first time since 2005 in the second quarter.

Fourth, we are currently executing our website optimization plan, which will include customer-focused enhancements like suggestive selling and advanced search techniques. Our Internet sales on a global basis continue to grow in 2008, with sales for the previous 12 months totaling $5 billion compared to $4.7 billion for the same period a year ago. In the second quarter, 81% of total BSD sales were online, up from 79% in the same period a year ago.

Overall, we believe we have slowed the rate of loss of market share among small to medium sized business customers and gained share in the public sector in large national accounts. While our performance may not demonstrate the improvements we’ve made in the business, we have made significant strides in our execution of the action plans and initiatives that we have laid out.

For example, our supply chain and customer service scores have both improved versus year ago. Our goal is to regenerate growth in this business while simultaneously focusing on margin recovery. As we look to the third quarter, contract sales continue to struggle. While direct is not positive, we are encouraged, as it’s the best trend we’ve had since 2005.

Let me now turn it over to Charlie Brown.

Charles E. Brown

Thanks, Steve. At $1.1 billion, the international division reported a sales increase of 13% for the quarter, compared to the same period a year ago. In local currency, this equates to a 2% increase driven by growth in the contract channel of 6%. The direct channel remained relatively flat.

Business softness in the U.K. and a weakening of the macroeconomic environment across Continental Europe constrained our sales during the second quarter. In the U.K., the economic environment continues to be challenging, with many economists reporting an increased chance of the economy falling into a recession.

Similar to what has taken place in the U.S., small business customers in the U.K. have been negatively impacted by rising fuel costs, higher food and housing costs, and limited access to capital.

Outside the U.K., our European business has also begun to show signs of weakening, with approximately one-third of the country reporting year-over-year revenue decreases in local currency and the remaining two-thirds reporting low- to mid-single-digit increases.

Divisional operating profit was $51 million in the second quarter, compared to $42 million in the prior year. Operating margin was 4.6%, up from 4.3 last year and about what we expected. The components of the operating margin increase versus a year ago included lower employee related costs of 120 basis points favorable due to the curtailment of a U.K. pension fund, and investments in regional offices, warehouse consolidation, Europe centralization, and acquisition related expenses and other favorable items that net to about 90 basis points.

It’s important to note that while the business environment remains challenging, we continue to press ahead with our action plans. I’d now like to update you on the progress we’ve made thus far.

First in the U.K., our customer service and call center performance are on track and the metric for on-time to complete performance now ranks among the best in the industry. We now see our operations and service levels as a competitive advantage that we can leverage to compete for share in this challenging environment. We have focused our marketing strategies on retaining and expanding existing customers, and our efforts within this area are beginning to bear fruit. We are also adding design, print, and ship services to the U.K. to drive profitable sales growth.

Secondly, we’re expanding Tech Depot into the U.K., France, and Germany from its initial start in The Netherlands.

Third, the international division is exploring opportunities to use tech services, a service that has met with success in North American retail.

Fourth, we are fully transitioning all back office transactional service functions from the U.K., France, and Germany to our share service center in Eastern Europe. We have incorporated the lessons learned from each of these efforts and as a result, our execution has improved with each subsequent transition. We continue to expect to have the balance of Europe transitioned by the end of this year. Short term, there are duplicate costs but long term, there are substantial savings.

And fourth, we continue to leverage our global sourcing office to increase direct import and drive private brand penetration in Europe and Asia. For example, the launch of our [4A] writing instruments in Europe was a success as the product line was well-received by our customers and private brand penetration rates have improved.

Our central distribution center in Belgium has now been operational for six months, with new assortments continuing to be centralized.

I would like to take a moment -- I would also like to mention that during July, we acquired a controlling interest in our longtime marketing partner, AGE Kontor & Data AB, a contract and retail office supply company operating in Sweden. This stake, which was purchased through a competitive auction, allows us to ensure continued service to our pan-European and global customers with operations in Sweden.

We have also received an unsolicited non-binding proposal from our partner in our Mexican joint venture, in which our joint venture partner proposes to acquire the capital stock in the joint venture owned by the company for approximately $430 million.

We have not engaged in substantive discussions with our joint venture regarding this non-binding proposal and there could be no assurance that any agreement on financial or other terms satisfactory will result from this proposal, or that any transaction will be approved or completed.

Finally, as we look towards the third quarter, we see modest sales growth in local currency, reflecting a continuation of the current trends across most markets.

That concludes my remarks on the international business, and I’ll now review our total company’s financial results.

During the second quarter, we recognized approximately $16 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 $412 million. This quarter’s charges primarily work with severance and some accelerated depreciation to consolidate the European supply chain facilities. We anticipate charges of $20 million for the balance of 2008 and $40 million in 2009, for a program total of $472 million. Our future charges may change as plans are implemented.

Also during the second quarter of 2008, the company initiated a voluntary exit incentive program for certain domestic employees that resulted in a charge of approximately $7 million for severance expenses in the period.

Additionally, the company received a non-cash gain of approximately $13 million related to the curtailment of defined benefit pension plan in the U.K., and approximately $16 million for a charge in the U.S. for inventory shrink.

We project that the changes in our cost structure should benefit pretax earnings by approximately $8 million to $9 million on an annualized basis.

Now turning to cash flow, during the first half of 2008, cash provided by operating activities totaled $138 million, compared to $293 million during the same period last year. This decrease primarily reflects a reduction in net earnings.

Depreciation and amortization decreased by approximately $10 million year over year, as we recognized less accelerated depreciation in charges in the first half of 2008.

Working capital increased by $239 million as compared to the second 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 consolidations in Europe.

We are not happy with this increase in working capital. We worked hard for many years to improve it and we are determined to reduce it once again.

I’d also like to take a moment to respond to the questions we received in regard to two issues, our capital spending and our revolving credit facility. First, we continue to be careful with our capital spending and we will make adjustments as necessary in regard to new store openings, store remodels, IP, and supply chain spending for the balance of this year.

As Chuck mentioned, we have reduced the number of anticipated store openings to less than 15 stores that had been long committed, and remodels to eight for the balance of the year in North American retail.

Our 2008 CapEx is anticipated to be about $375 million, slightly more than 2% of 2007 annual sales and about 130% of depreciation and amortization. About 25% of CapEx is due to store openings and remodels, and approximately 40% is due to IT and supply chain.

Second, as you know, we renegotiated a financial covenant under our $1 billion revolving credit facility in the first quarter of 2008 based on the outlook for business conditions at that time, and that amendment was filed as an 8-K on March 10th. The key financial covenant is the fixed charge coverage ratio and as of the second quarter of 2008, the company has maintained a fixed charge coverage ratio within the required range and ended the second quarter with over 50% of the revolver capacity available.

Also, based on current projected operating results, the company anticipates remaining in compliance with all of the covenants.

However, given the uncertain environment, we feel its prudent to revise our financing plan and have begun the process to put in place an asset-backed loan facility to ensure appropriate liquidity for our business. As of yesterday, we have secured a fully underwritten asset-backed facility with capacity in excess of $1 billion that we expect to have in place before the end of the third quarter.

Now on the balance sheet, we ended the second quarter with $157 million in cash and short-term investments. Our investment in inventory totaled $1.6 billion globally, up 4% from the same period last year. This increase was driven primarily by the impact of foreign exchange rates and duplicate inventories for warehouse consolidations in Europe.

Excluding the impact of foreign exchange, total company inventory was up less than 1% versus year ago. Total North American inventory levels were slightly down versus a year ago. In North American retail, inventory per store was $909,000, down 6% year over year. On an average basis, inventory per store was $927,000 for the second quarter of 2008, reflecting a reduction of 9% from the same period a year ago. These changes were the result of improved inventory management, as well as mitigation of inventory risk through clearancing activities.

Our net debt at the end of the second quarter was $756 million, and with that, I’ll turn it back to Steve Odland.

Steve Odland

Thank you, Charlie. Clearly we’re disappointed with the results this quarter. The results do not mirror the amount of effort that our team made this quarter, nor do they reflect the enormous progress we’ve made in execution and continuing to strengthen our management team. We continue to take deliberate actions to improve our management team and add to it. Over the past 12 months, we’ve hired a president of our BSD division, we have built a new management team in the direct business, we have restructured merchandising with a new EVP and three new vice presidents, we have increased the leadership capabilities in supply chain with the addition of an EVP of supply chain and a new vice president of inventory. All of these organizational changes are intended to return our business to profitable growth and we are pleased with the contributions that these new leaders are making to our organization.

Although this past second quarter is typically the lowest sales quarter of the year due to seasonality, our sales were worse than expected, especially in North American retail, and we hit our fixed cost levels very quickly and delevered fixed expenses.

We also had items that lowered our gross margin during the quarter. We do not believe that we’ve received any measurable benefit from the economic stimulus checks and believe we actually may have been hurt as customers spent them and the balance of the basket elsewhere. However, we are encouraged that the third and the fourth quarters have historically been a larger percentage of our annual sales revenue. If you look at North American retail, quarter three and quarter four have averaged 25% to 26% of the total annual volume over the past three years versus 22% of the annual volume in the second quarter. If these proportions hold true this year, we should be able to expand margins sequentially due to volume leverage alone over our fixed costs in this business for the balance of the year.

Before we open up the call to questions, I would like to make it clear that we are committed to improving the performance of Office Depot and we’ll continue to do everything we can to profitably grow the top line, cut costs, reduce our capital spending, and improve cash flow.

I’d now like to open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Matt Fassler. Please go ahead.

Matt Fassler - Goldman Sachs

Thanks a lot and good morning to you. Two questions; first of all, the Mexican business, it looks like from your K that business, I think in its entirety, if I understand the disclosure, generated between $60 million and $70 million of net income, and I guess you own half of that. I guess what I’m trying to do is to reconcile that number with the number that you, the equity income number that you disclosed on your P&L that presumably includes Mexico and a whole bunch of other things, such that if you were to sell it, what the income hit would be to offset the cash proceeds.

Charles E. Brown

The income number that you suggested is -- you are actually correct. It may be a little bit higher in terms of what they will generate this year in terms of net income. And we do account on the equity basis for that and it’s 50%.

In terms of its contribution to EPS, you know, it’s going to be in the range of about -- you know, contribution is about $40 million pretax, I think, would be our share of it.

Matt Fassler - Goldman Sachs

Do you bring those earnings in pretax and then tax them on your own P&L, or do you bring them in kind of above the pretax line but then not charge income tax on them?

Charles E. Brown

No, no, they are tax affected. They show up in other income.

Matt Fassler - Goldman Sachs

Okay, so you’re saying basically $40 million in net income to Office Depot, so that would be kind of a 10-multiple, more or less, on some of that business?

Charles E. Brown

And again, what we’ve -- I would stress the very preliminary nature of this. This is a number -- you know, we shared the number with you. That number, there’s been absolutely no discussion around what the appropriate number should be. That was their indicative offer.

Matt Fassler - Goldman Sachs

My second question is just trying to understand the international sales trends a bit better. It looked from your disclosure like the organic sales trends, or rather the ex currency sales trends actually improved from Q1 to Q2, so if you could kind of comment on the difference in the Q1 number versus the Q2 number, what the moving pieces were there. Because your commentary was not as constructive as that number seemed to imply.

Charles E. Brown

Well, I think the second quarter, we did experience growth. We’re seeing most of our growth in the contract channel, which as you know, Matt, since you’ve followed us for a long time, the old [Gilbare] business forms a basis for that business, and we’ve been successful in turning that from a decline into a growth story. So that’s where most of it is.

Our sales did soften late in the quarter, just as they did here in North America, so we were stronger in April and May than we were in June.

Matt Fassler - Goldman Sachs

But were you not down ex currency international in Q1 and up in Q2?

Charles E. Brown

Yes, we were up.

Steve Odland

Matt, I think you’re right. We may be downplaying it a little bit. You’re factually correct. We were up in local currency in international this quarter. We were down last quarter. I think what we are trying to do is temper it because we are worried about weakening economies there as well as the business mix, as Charlie said, because of the contract growth there.

Matt Fassler - Goldman Sachs

Were there any acquisitions? I mean, the Sweden thing I guess came too late to impact the quarter -- kind of a clean, organic number.

And then finally, just on the tax rate, it looked like to get to your adjusted number, we need to do something in the mid- to high-teens. I understand that in a very low income quarter, that could look a bit funky. Where should we be thinking for the rest of the year?

Charles E. Brown

I think for the rest of the year, we should be thinking probably in the high 20% range, 28, 29.

Matt Fassler - Goldman Sachs

Thanks so much, guys.

Operator

Thank you. Our next question comes from Kate McShane. Please go ahead.

Kate McShane - Citigroup

Good morning. I was wondering what your outlook or opinion was on reducing or potentially closing down stores. I know you announced today that you are reducing the number of stores you are opening but what is your view on shutting down any under-performing stores?

Steve Odland

We will perform our regular FAS process in the fourth quarter. That’s our annual time -- third quarter, sorry. That’s our annual timing here going forward. We have looked at closing stores and we’ve closed a few each quarter and we’ll continue to do that over time as we reposition them and so forth.

Kate McShane - Citigroup

Okay, but you don’t plan to get more aggressive?

Carl Rubin

Kate, to Steve’s point, we continue to look at our stores. We’ve closed about 100 stores over the past three, four years that have been under-performers and it’s just an ongoing practice for us, so we’ll continue to practice that.

Steve Odland

At this point in time, we don’t have plans or estimates for any significant numbers of closures.

Kate McShane - Citigroup

Okay, and then one other question -- can you talk about your promotional stance going into back to school? And how should we be thinking about markdowns year over year?

Carl Rubin

It is a promotional timeframe. We have altered our promotional strategy to maximize the profitable sales that we have. There are some very aggressive prices out there. We have scaled back what we’ve done compared to previous years. We continue to see customers cherry-picking quite a bit, in the sense that they are coming in and they are buying the very low margin items and not picking up the basket to the level that we have seen in the past. So that’s my greater concern.

Steve Odland

I think that our point of view, we watched trying to drive our customer traffic. We’ve been able to drive traffic but they don’t come in to build basket. We’re very cognizant of that so our view is that we’ve got to be careful about our price promotion and we intend to be conservative on our price promotion. We don’t intend to give away product and give away margin. We know we’ve got to build these margins and we want to do that through this period of time.

I think that the primary focus will be in our Worklife Reward area. We’re very pleased with the build on our Worklife Reward members. Those members tend to be more profitable. The margins tend to be higher and so our focus for the balance of the year, and especially during back to school will be to deepen our relationship with those Worklife Reward members in order to build their share of -- our share of wallet with them and build our market share with a more loyal group.

Kate McShane - Citigroup

Okay, that’s helpful. Thanks very much.

Operator

Thank you. Our next question comes from Chris Horvers. Please go ahead.

Chris Horvers - JP Morgan

Thank you and good morning. Can you talk a little bit about first on Mexico, your decision process, how you would think about what kind of scale in economies that business gives you in operating that joint venture versus divesting that and taking cash onto your balance sheet? And then secondly, does the continued struggles in the off superstore environment and the change with Staples and Corporate Express make you think any differently about strategic options out there?

Charles E. Brown

I’ll take Mexico. First of all, I’d point out that we’ve been in Mexico for about 12 or 13 years with this partner, and it’s a business -- it’s a very, very good business, which is why our partner has come forward and with this unsolicited offer. It is the market leader in Mexico -- and by the way, it operates in Mexico and the balance of Central America as well.

I would stress again the preliminary nature of our discussions. This letter from our partner was unsolicited and it came in last week and we felt an obligation to share it with you. If we can’t negotiate the right terms in terms of increasing our shareholder value and using that cash effectively, then there is no guarantee that we’ll do the transaction.

And we have not yet started discussions. We’ll start discussions in a couple of weeks.

Steve Odland

I think our point of view is that we are open-minded to the outcome of their approach, and if this happens, if we are able to proceed with some sort of transaction, this is a meaningful sum of money and it could create a shareholder value creating event. Our current banking facility prohibits share repurchase, as you know, but we’ve announced today that we have a new asset-backed facility agreed to and it may allow some, so we will study the possibilities coming out of the proposal on the Mexican JV and again, we’re open-minded to it.

As it relates to other consolidation, we believe and we’ve been consistent right along that consolidation needs to happen and we are open to possibilities there. We need to ensure it’s right for -- you know, any move would be right for our shareholders and have the right amount of risk balance in there. The whole foods discussion and the case that was announced yesterday needs study by everyone. There’s uncertainty in the regulatory environment but this is clearly a highly fragmented industry and we believe that consolidation would be good for customers, good for shareholders, and we hope it happens over time.

Chris Horvers - JP Morgan

Does your current debt levels and/or covenants in the new facility preclude any kind of large debt finance transaction?

Steve Odland

We haven’t finished all of the new debt facility covenants and everything at this point, but it’s -- clearly the current revolver that we have in place was very restrictive. Our intent and our hope is that the new asset backed facility will allow more flexibility for us.

Chris Horvers - JP Morgan

Thanks very much.

Operator

Thank you. Our next question comes from Mike Baker. Please go ahead.

Michael Baker - Deutsche Bank

Thanks. So two questions; one is on the shrink, I don’t remember that being called out before as this big of a margin decline, so could you just give us a little bit more detail on what happened there and how you mitigate that?

And then the second question is Steve, you said that margins could conceivably get better sequentially in the third quarter. As you start to come up against some -- the big declines in 3Q last year and then particularly 4Q last year, any thought of margins potentially improving year over year rather than just sequentially? Thanks.

Steve Odland

That’s a good question, Mike. We do annual physical inventory throughout the entire system, including stores, [cross docks], and distribution centers. That annual process was completed in the second quarter, and so -- and then we do a true-up. And so in this second quarter, we completed that and there was a difference between book and actual inventory, and we took $17 million in a shrink charge to cover the difference. So if you think about the second quarter operating performance, my opinion is that the underlying performance is better than the results show, because you’ve got that $17 million hit that was not related to the operating of the second quarter. You’ve got the severance hit of about $7 million and then legal costs and so forth.

So you know, there are positives and negatives in every quarter every year and so forth, but this is an unexpected amount. So that’s my point of view on it.

Charles E. Brown

Mike, let me just add a little more color as well. We did have an adjustment last year as well but we took it in the third quarter rather than the second quarter and the actual shrink number was pretty comparable. The increase, and the reason it got called out, was really related more to some process issues we had around direct import, which those have now been fixed going forward. But in the quarter, it was a meaningful number, which is why we called it out.

Steve Odland

As it relates to margins, what we’re trying to -- you know, it’s an uncertain environment as we all know, but if you look at just the North American retail business, which is where the softness was beyond our expectations and not -- you know, there are differences in every business but the North American BSD division and international performed roughly about where we expected it to. It was North American retail that softened but if you look at that business, it is a very seasonal business and so what happens historically, just look over the last three years, the sales by quarter, those are -- that’s out there. Those are actual, and I think that you will see that the mix of business by quarter throughout the year is the high first quarter. Second quarter is generally about 22% of the total business. The third and fourth quarters account for 25% to 26% of the business.

What happened in the second quarter on the North American retail business is that we hit sort of the fixed levels of expenses in labor and occupancy cost and so forth. So Mike, my point of view is that as we go forward here, if the third and the fourth quarters are the same percentage of sales as they have been historically, we ought to get leverage going forward simply on that. We are hopeful also that as we lap the third and the fourth quarters of last year, that the comparisons become easier but we want to be cautious in how we approach that.

Michael Baker - Deutsche Bank

So in effect, if you comp negatively but less negatively so to get to those percentages you just discussed, then you should actually leverage your SG&A -- you don’t even need a positive comp, just less negative?

Charles E. Brown

Yeah, essentially that’s correct, Mike.

Michael Baker - Deutsche Bank

Okay, thanks.

Operator

Thank you. Our next question comes from Colin McGranahan. Please go ahead.

Colin McGranahan - Sanford C. Bernstein

Good morning. Thank you. I want to start with an easy one -- just the pension impact in the international division, it wasn’t clear to me if that was kind of a one-time gain recorded in there or if you eliminated that pension program and until you anniversary, will have lower operating costs?

Charles E. Brown

The amount recorded in the second quarter was a one-time gain on the curtailment of the plan. Essentially, this was a defined benefit plan that came with the [Gilbare] acquisition. We curtailed that plan and of course moved the people over to a defined contribution plan as its replacement, so this is a one-time event. However -- in terms of the size of this; however, we will enjoy lower pension costs going forward than what we were paying in the past because it’s a defined contribution plan.

Colin McGranahan - Sanford C. Bernstein

Okay, that’s helpful. And then second question for Steve, just to focus on the capital allocation and cash usage, in the context of working capital performance that has continued to be not very good, cash burn year-to-date and bumping up against some credit constraints, and I know you have a credit facility that can help you with that but certainly you are bumping up against some credit limits. It looks like in the second quarter you spent $85 million in acquisitions, of which $78 million of that was new stuff for a JV in India, and buying in China and Israel. Post second quarter, it looks like you are doing something else on a JV in Sweden, and then we hear today that for fiscal ’09, there’s going to be another 45 new stores and I understand these are committed leases, but I would think in the current environment, you would have some opportunities.

And I’m just -- I’m trying to understand why that spending that kind of cash on longer term growth in this kind of an environment with your kind of financial performance is at all a good idea.

Steve Odland

There have been some expenses on puts that were part of previous deals going back first of all to Israel, which was a deal going back to the mid-90s which were part of the structure of that deal, our JV partners had the ability to put their shares to us. The same thing in our China joint venture, and so there were expenditures for puts that were contractually obligated in prior years.

We did complete and we announced at the end of the first quarter a joint venture with the Reliance Group, which is the largest private or public company in India, one of the most successful in India to get a toe-hold going in India for that. It’s a relatively modest amount of money to access a market of over a billion people in one of the most dynamic economies in the world.

The Swedish thing is a relatively modest amount of money where they decided to sell, they are our marketing partner, they do service our customers, our global customers, which are pan-European customers. And if we lost that ability to access and to service those customers there, we would jeopardize potentially a significant amount of sales throughout Europe elsewhere, and so we felt we needed to take a stake there. We took a 51% stake rather than buying the whole thing in order to conserve cash but to preserve our ability to take care of customers.

So it’s a delicate balancing act but what we are trying to do is conserve as much cash as possible on one hand while not damaging the future of the company on the other hand. And it is delicate because these are judgment calls.

Going forward, we have moderated our store openings. We are down to about 15 stores for the balance of the year, which are all committed leases and we said approximately 45 stores for next year. We’re working to lower that but as you know, the pipeline in real estate is 24 to 36 months. These are leases which have been pushed out from -- you know, the releases that were pushed from last year into this year, this year into next, and we will get out of every lease that we think we can economically get out of and we are negotiating on that but what we are saying is that we’ve got about 45 commitments for 2009.

So we’re taking every effort we can to conserve cash. The issue on the working capital is largely an aging of our inventory. It’s good inventory but at the same time, the -- as sales have slowed, we’ve outrun the credit terms on those and so you’ve seen our AP to inventory come down and that’s a result of that inventory aging, so it’s not fashion oriented or perishable but at the same time, it is aged on the credit terms.

So we’re mindful of all this. We’re not happy with it and we’re doing everything we can to work this inventory through. I think we did a great job of reducing our inventory on a per store basis this quarter. I think we were down 9% on an average basis over the course of the quarter in North American retail, despite the softness in sales. You can see that that demonstrates focus on this area.

Charlie, I don’t know if you have any other thoughts.

Charles E. Brown

The only thing I would add, on the acquisitions, the bulk of the number that you referenced, Colin, was the result of puts in Israel and China. We would have preferred not to have bought that incremental piece of business at this point in time but clearly we were contractually bound from this from earlier years. And in terms of Sweden, had we not acquired this controlling interest in our partner, we would have been closed out of Scandinavia forever.

Colin McGranahan - Sanford C. Bernstein

Okay, that’s helpful. So with the exception of India, a lot of this stuff was simply unavoidable?

Charles E. Brown

The other thing I would add, Colin, is in the receivables and inventory area, one of the largest impacts was actually foreign exchange.

Colin McGranahan - Sanford C. Bernstein

Right.

Charles E. Brown

Because we hold most of those inventories in --

Colin McGranahan - Sanford C. Bernstein

Yeah, I understand. And then just a final quick one, Steve, just in terms of the 2Q margin miss, I understand sales came in somewhat below expectations but it seemed like the magnitude of that was very large. Was that -- was the swing in North American retail more the surprise on shrink? Because the comp at negative 10 was not materially different than the comp at negative 9 in last quarter.

Steve Odland

Well, the quarter’s performance was consistent with what we said and what we told you we expected last quarter, with the exception of softer North American retail comps, we did not expect it to be down 10. That deleveraged fixed costs because we hit the lowest percentage sales in the year. We told you we were worried about that, of course, but it was lower than expected.

And then we had unexpected items in the quarter, including the shrink charge of $17 million, severance charge of $7 million, and then legal costs and so forth as we pointed out that were significant. So I believe that our underlying performance is actually better than the results show, and then as we go forward, if you just look at the percentage of sales, as I mentioned earlier on a previous question, we should be able to better leverage our fixed expenses.

This second quarter is always the toughest quarter of the year from a margin standpoint. It is -- we white-knuckle it every year but this year especially, we did everything we can to take the cost out.

I think the fundamental issue here, Colin, is that our customers are small businesses and our customers are hurting. They are cutting back on their expenses, including office supplies, office furniture, computers. They are doing everything they can to cut costs. Your business is doing everything it can to cut costs.

Our strategy is to alter our offering to be more value-oriented, to sign up these Worklife Reward customers to deepen that share of wallet and market share, cutting our spending, cutting our CapEx and we’re ensuring our liquidity. We’re doing all of those things, which we believe are the right things to do in this environment.

Colin McGranahan - Sanford C. Bernstein

Okay, that’s helpful. Thank you, Steve.

Operator

Thank you. Our next question comes from Dan Binder. Please go ahead.

Daniel T. Binder - Jeffries & Company

Good morning. A few questions; first, I was wondering if you could give us a rough idea of what the cost of the new credit facility will look like versus the cost of credit on the old facility, and if there are any other more or less onerous terms tied to that new facility?

And my second question was tied to vendor rebates. Just wondering, with the significant decline in retail sales and obvious decline in delivery, are we close to breaking new thresholds on vendor rebate rates, such that we’ll have a potential issue later this year?

Charles E. Brown

Let me -- I’ll take the credit facility question. The revolver that’s currently in place has a number of restricted covenants because it’s obviously an unsecured facility, and that facility was put in place at the peak of good times, if you will. And so we’re paying about LIBOR plus 65 basis points on the drawn facility. Obviously we’re in a different situation now and banks are scrambling. Banks themselves are having a pretty difficult time. But we felt it prudent to put this facility in place.

What we are looking at is LIBOR, on the new facility, LIBOR plus about 200 to 225 on the drawn facility, so it’s more expensive but the covenants are substantially less because it’s a secured facility.

Daniel T. Binder - Jeffries & Company

When you say the covenants are substantially less, can you just give us an idea of what the fixed cost ratio, coverage ratio will look like?

Charles E. Brown

For example, on our current revolver, the fixed charge coverage ratio is 1.7 times. On the new facility, the fixed charge coverage ratio is about 1 to 1. But that ratio doesn’t even spring until you are something like 85% drawn. So you can see that you are not fighting against these type of covenants on a quarter to quarter basis and that’s why we think it’s more prudent to move to an asset-backed facility.

Daniel T. Binder - Jeffries & Company

Okay.

Steve Odland

And Chuck, on the vendor rebates?

Carl Rubin

On the vendor rebates, we’ve said before that we think on an annual basis, that the rebates as a percentage of our sales is going to be consistent with what it was in 2007. We still view it that way. The market has toughened up but vendors are also -- we’re working very closely with them. We have eliminated virtually all of our [inaudible] that caused some problems last year. Again, we anticipate on a percentage of sales that it’s going to be consistent on an annual basis.

Steve Odland

But the challenge here, Chuck, is essentially that it’s geared to purchases.

Carl Rubin

It’s geared to purchases and we’ve been tightly managing those purchases, and we commented in our prepared comments that we are aggressively going through line reviews and we’re making -- we’re having some good progress on that, so overall it’s as I said a minute ago; we think it will be flat on a percentage of sales basis with last year.

Daniel T. Binder - Jeffries & Company

And then just as a follow-up, there’s been some press about this U.S. communities contract. I was wondering if you could just address what’s going on with that and whether or not there’s real risks with it. And then lastly, with the early retirement package, I know it may be hard to gauge it but can you give us an idea of what kind of talent may have been lost in that process and what was ultimately really achieved by doing that and why you did it?

Steven M. Schmidt

Let me take the U.S. communities question. First of all, our relationship with U.S. communities is as strong as it’s ever been. U.S. communities actually just completed an audit of four major markets and our performance was absolutely stellar. In fact, the press release was actually put out that talked about the results of that audit, and we continue to have a great relationship with U.S. communities and we’ll continue to develop that relationship going forward.

Steve Odland

And then on the voluntary exit plan, it wasn’t actually an early retirement plan; it was a voluntary exit plan. It was conducted here at our corporate headquarters and there were about 130 people, largely administrative people and -- but people really spread throughout the organization that helped us to lower our cost and adjust our G&A to our sales level and while we’ll miss many of them, I think that we are just fine in terms of the talent we need to run the company for the long-term.

Daniel T. Binder - Jeffries & Company

Thanks.

Brian Turcotte

Melissa, we have time for one more question.

Operator

Thank you. Our last question comes from Gary Balter. Please go ahead.

Analyst for Gary Balter - Credit Suisse

Good morning. It’s actually Seth [Hangray]. A quick question on the shrink; you mentioned that it’s in your annual physical inventory count that led to the shrink charge this quarter. You took one as well last year in Q3. I think you also took a pretty significant charge in Q4. Could you just tell us, differentiate for us what these charges are and how we should think about shrink going forward?

Charles E. Brown

Yes, we did say -- I guess the color I would add is we took about $17 million charge in the second quarter. Last year in the third quarter, it was around about $6 million. The delta, that $10 million was really related to direct imports and it’s a process, as you know. I mean, here we’re bringing goods directly in from China ourselves, and we had some process issues that we needed to shore up, which we’ve now taken care of.

So as we look at shrink going forward, we think the process issues that led to this unusually high number of $17 million in the quarter have been dealt with and so we think it will return to more normal levels going forward.

Steve Odland

The actual shrink level that’s governed by theft in the stores and loss of inventory due to exposure to customers is one of the lowest in all of retail. We’re running closer to 1% and so the issues here were related to shortages from shipments that caught in the true-up and we put the processes in place to plug that going forward.

Charles E. Brown

And the other thing I would add is we report shrink reserve every month as a percent of sales. I mean, that’s the way most retailers do it. And to some extent, the $6 million that we reported in the second quarter is reflective of the fact that our sales were lower, so therefore the amount of accrual was actually short. So it was really the direct import piece that was the main driver of the 17.

Analyst for Gary Balter - Credit Suisse

Okay, understood. Thank you. And then just secondly on vendor support, you mentioned talking tightening of vendor support, understandable in the environment. Does that also include tightening of terms in terms of days to pay?

Charles E. Brown

No, I don’t think it includes the payment terms. I don’t see those being reduced. We’re working in fact hard on extending them.

Analyst for Gary Balter - Credit Suisse

Okay. Just following up on that though, with the new facility, this is the first time you are going to have the inventory tied in with the bank, so what is -- will that change -- like, vendors obviously now no longer have direct access to that inventory. What have you heard from vendors or are vendors not aware of the new structure?

Charles E. Brown

I think that the new facility will have the inventory and receivables pledged as collateral, but in essence the facility will work the same as it did before. It will be a drawn facility. It’s just in case we default, which obviously we don’t see as a possibility.

Analyst for Gary Balter - Credit Suisse

Right, but previously it would have defaulted in one pool and now that -- now the receivables and inventory go through the banks first, right?

Charles E. Brown

Well, if we were to default and go into liquidation and bankruptcy, then of course yes, it would -- the banks would have a first call on that.

Steve Odland

But that’s so far from the realm of what we’re talking about. We’re only half drawn on the current facility.

Charles E. Brown

Actually, we have more than half of the current facility undrawn at present, so the issue here candidly was really around the covenants. It wasn’t on the drawn. It is chasing -- this fixed coverage charge ratio quarter to quarter, we didn’t think, and given the tightening credit markets, was the right thing for us. And so because the covenants are substantially reduced on an asset-backed facility because you have the asset backing, you know, it gives us relief in the covenant area.

Steve Odland

I think our shareholders should feel really good about this.

Charles E. Brown

It’s actually a good thing.

Steve Odland

Because given what’s happening in the liquidity markets, this assures access to capital and we see -- we think a lot of firms are going to be moving to this market. We’re early in this process. We’re not at the covenant level. We don’t project to be at the covenant level and we’re less than half drawn but we think it’s a prudent thing to guarantee that we’ve got liquidity for the long run and it’s a little more expensive but that’s a small price to pay for the insurance policy of having access to liquidity and making sure that we can run this business for the long-term.

Analyst for Gary Balter - Credit Suisse

No, that I appreciate -- just one other thing to follow-up on; there was a comment made about Georgia, and we read all this trade press obviously and some of it is very negative and obviously somewhat biased in certain regards. Can you discuss why the contract was terminated, and also expand that to what’s happened in California and Florida, just to clarify all that?

Steven M. Schmidt

First of all, with respect to the publicity that’s come out on this subject, you know, really much of what has been said is really incomplete, it’s inaccurate, and recites all types of facts that are completely out of context. We’re not infallible but at the same time, we are absolutely committed to contract compliance and we’ve been doing this, and so when the facts come to light in almost every single case, we’ve basically have taken what’s been said, disproved it, and have validated our position.

In the case of the State of Georgia, we again what we talk about was we were awarded a single source, single provider contract in March of ’07. Then the contract was canceled. We challenged that and basically came to an agreement with the State of Georgia, which first of all we always have been doing business in the State of Georgia. We continue to do business in the State of Georgia and basically after discussing the facts, came to an agreement to continue to do business in the state and that basically, as all of our contracts have, any customer has the right to cancel the contract basically with proper notice, so we were able to do that.

And then regarding other state contracts, the audit process is something that goes on as a part of normal business and we are cooperating with the State of California as we are with other states where these audits go on and we feel confident that the results will be favorable once completed.

Analyst for Gary Balter - Credit Suisse

Thank you. That’s helpful. Thank you.

Steve Odland

Okay. I think that we’ve run over our time. I would like to thank everybody for joining us today and once again make clear that we are absolutely committed to improving the performance of the company and we will do everything we can to profitably grow the top line, cut our costs, reduce our capital spending and improve our cash flow to add shareholder value over the long-term. Thanks for joining us today.

Operator

Thank you. That does conclude today’s conference. You may disconnect at this time.

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Source: Office Depot F2Q08 (Qtr End 6/28/08) Earnings Call Transcript
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