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United Stationers Inc. (NASDAQ:USTR)

Q2 2008 Earnings Conference Call

August 1, 2008 11:00 am ET

Executives

Dick Gochnauer - President and CEO

Vicky Reich - SVP and CFO

Cody Phipps - President, United Stationers Supply

Analysts

Dan Binder - Jefferies & Company

Jonathan Lichter - Sidoti & Company

Rob Damron - 21st Century Equities

Simon Porter - First Manhattan

Operator

Ladies and gentlemen, thank you for standing by. And welcome to the second quarter 2008 United Stationers earnings conference call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions). As a reminder this call is being recorded today, August 1, 2008.

And I’ll now like to turn the conference over to Mr. Dick Gochnauer, President and Chief Executive Officer. Please go ahead.

Dick Gochnauer

Good morning every one and welcome to United Stationers conference call to discuss our second quarter 2008 results. Joining me today is Vicky Reich, our Chief Financial Officer and Cody Phipps, President of United Stationers Supply.

Before we begin, I would remind you that the information we share on this call may contain forward-looking statements which are based on certain assumptions. What we say may be affected by the risks and uncertainties in our business, markets and economy.

Despite our best efforts, actual results may differ from what you hear today. To learn why this might happen, please review the cautionary language in yesterday’s news release and in our filings with the SEC. Also remember that the information on this call should be considered current only as of today. After this, please use it for your reference and know that we assume no duty to update it.

Shortly after the call ends, you may find an archived version of it on our investor information section on our website at www.unitedstationers.com. You also can find a copy of our second quarter news release there as well.

Here is the format for this morning’s call. Vicky will begin by discussing the highlights of our second quarter and our first half financials with you. Then I will talk about the details behind our sales for the quarter, present the progress we are making on our six value drivers and share our current outlook for the second half of 2008. After that Vicky, Cody and I look forward to answering your questions. Here is Vicky to start us off.

Vicky Reich

Thank you, Dick and I would like to add my welcome to everyone on the call this morning. Before we get into a more detailed look at results, I would like to provide a few comments to put the past quarter’s performance into context.

Despite continued difficult market conditions, we achieved increased second quarter sales and earnings per share. Our sales growth was boosted by the ORS Nasco acquisition and modest organic growth. Our WOW programs and cost controls were effective, and enabled us to mitigate a significant portion of the inflation in fuel costs.

While gross margins were down versus last year, we made headway sequentially in closing the margin gap and we made further progress in working capital efficiency resulting in strong operating cash flow. Our second quarter results included two items that I would like to highlight. These were a $4.7 million pre-tax gain from selling our former corporate headquarters and a $6.7 million pre-tax asset impairment charge related to capitalized costs or SAP’s RTS solution, which Dick will discuss in more detail later.

My comments today will focus on our adjusted results excluding these two items, so you can get a better sense for the underlying performance in our business. It is also worth noting that the second quarter results include the incremental impact of the December 2007 acquisition of ORS Nasco.

Let’s begin with second quarter sales, which rose almost 10%. 7% of this growth came from ORS Nasco. Our organic growth rate excluding ORS was about 2.6% and reflected the following dynamics. First, the Easter holiday fell in last year’s second quarter versus this year’s first quarter, which led to higher sales in this period. Second, we experienced solid sales increases in the janitorial and breakroom category, in our new customer channels including [ETO] and in our private brand products. And third, a modest amount of price inflation. We estimate less than 2% in the trailing 12-month period.

As I will discuss shortly, the inflation picture is going to accelerate in the second half. These positive factors help to offset the challenges we are facing in this soft economy. Customers are continuing to defer discretionary purchases like furniture and are trading down to lower-cost products. Dick will offer you more details on sales in a few minutes.

Gross margin for the quarter was 14.5% of sales, down 33 basis points from last year. The addition of ORS Nasco increased gross margin by about 20 basis points. So the base business was down about 50 basis points. The downward pressure came from several areas. First, lower inventory cost adjustments. The prior price increases this year are heavily weighted to the third and fourth quarters whereas the increases in second quarter were actually lower than a year ago.

Second, fuel cost inflation. Diesel was up 55% versus last year costing us about $4.6 million before the impact of our mitigation actions and third, a lower margin product mix. This wasn’t so much across product categories as within categories, where customers are buying the basics and seeking value or putting off the more discretionary purchases. Partially offsetting these unfavorable items were first, goods success with WOW programs with a strong focus on freight cost savings where we offset more than 80% of the fuel inflation and facility productivity initiatives to help counter the effects of slower volume growth in our core office supplies business.

Second, supplier allowances were also favorable in the quarter. As expected our purchases of inventory tracked closely with sales unlike the unbalance in the first quarter. We continue to negotiate program enhancements from suppliers which is helping to counter the effects on allowances of slower sales growth and a lower mix of the discretionary products that tend to have higher allowance rates. I would like to provide a little more color on how our supplier allowance programs are structured since I know this has been a source of questions regarding the impact on our margins.

You may recall that we shifted our supplier programs two years ago to a predominantly variable format versus the historic component that was a fixed annual catalog page rate. We made this change in recognition of the impact at e-commerce and more targeted custom catalogs would have on our overall marketing portfolio in the future. Approximately 80% of our allowances are now variable. Many of the individual elements of our supplier allowance programs are variable based on a negotiated rate applied to purchases of a given manufacturer and/or product line. Those rates vary significantly across the broad spectrum of products that we distribute and therefore sales mix can have a material effect on the overall supplier revenue generated.

Some of our programs include growth or volume Tiers, which mean that the allowance rate earned can increase based on achieving certain growth targets. Approximately one third of our purchases are subject to these programs. So in general, supplier allowances may increase or decrease our gross margin rate quarter-to-quarter when purchases are significantly higher or lower than sales as happened in the first quarter, or our sales mix changes, or we negotiate supplier program enhancements, or we achieve growth or volume tiers.

Now let’s move on to operating expenses which as percent of sales increased from 10.7% last year to an adjusted 10.9%. Adjusted operating expenses totaled $136.8 million for the quarter versus $122.6 million last year. The addition of ORS Nasco accounted for $9.5 million of the increase. So the base business was up about 3.8%. Several factors contributed to the increase. First, costs ramped up in Lagasse to serve a significant increase in new business in our janitorial and breakroom category where sales grew at a 14% clip. Second, general inflation affecting compensation and other costs while still at normal historic rates has been more challenging to offset in our core office supplies business due to lower sales volume and we are experiencing some de-leveraging.

And lastly, we are making investments in key initiatives that are helping us build an even stronger business for the future. These initiatives encompass facility projects including start up of our new Florida distribution center and a number of Lagasse projects as well as IT and marketing related projects. Our progress on WOW continues despite upward pressure from general inflation and the de-leveraging effect of lower sales volume in our office product business. Few key areas of WOW accomplishments included warehouse supplies and order quality.

Warehouse supplies have been reduced significantly by leveraging our total company purchase volume in negotiating lower costs. Our emphasis on quality has helped to reduce our overall returns which not only lowers our expense to process returns but has a favorable impact on margin as well. As we indicated in the first quarter the tough economy has led us to make some course corrections for the balance of the year including further expense reductions. We began to see results in the second quarter from our hiring freeze and distribution center productivity initiatives.

We expect this progress to continue in the second half of the year. Operating margins for the quarter declined from 4.1% to an adjusted 3.6%. Financing costs versus last year’s second quarter include the benefits of lower rates and our strong free cash flow over the past year. Partially offsetting the impact of funding, share repurchases, and the ORS Nasco acquisition. The tax rate of 38.3% for the quarter reflects our updated estimate for the full year rate to about 38.6%. EPS was up 14% from $0.84 to an adjusted $0.96. The second quarter results included about a $0.07 per share net benefit from share repurchases over the past 12 months and approximately $0.08 per share net benefit from ORS Nasco.

Speaking of ORS Nasco. This business had a strong second quarter. Sales were $80 million for the quarter and are trending to achieve the 8% to 10% growth target for 2008. We are realizing the planned synergies. The $0.08 of accretion in the quarter or $0.12 year-to-date puts us on course to deliver at the high end or above the expected 15 to $0.20 of EPS accretion this year.

Now let’s take a closer look at the balance sheet where our working capital improvement initiatives are continuing to progress. Inventory management was a highlight in the second quarter, as our teams are diligently optimizing the investment here while providing high order fill rates for our customers. Excluding the impact of ORS Nasco, inventory declined by $20 million or 3% versus the prior year and inventory turnover improved from 6.3 to 6.7 times.

Accounts payable excluding ORS Nasco was up about 13% or $49 million from a year ago. Our accounts payable leverage or AP as a percent of inventory excluding ORS was 70% versus 60% last year. Accounts receivable excluding the impact of ORS and the effects of securitization were up $19 million or 3% versus last year. Our receivables performance remained solid with second quarter average day sales outstanding flat versus last year at 50 days. Bad debt expense was up slightly versus last year but remains at our historic rate as a percent of sales. We are monitoring credit exposures and collections very carefully.

Our overall working capital efficiency improved from 16.4% to 15.3% of sales, despite a negative impact from ORS Nasco of about 30 basis points. Its worth noting that our ORS Nasco’s working capital investment is slightly higher than the base business. ORS is contributing positive free cash flow and making nice strides in working capital efficiency.

To date this year, net cash from operating activities adjusted for the effect of changes in accounts receivable sold, totaled $61 million. This compares with $75 million in the same period a year ago, when we were coming off a high year-end 2006 working capital balance.

Capital expenditures of nearly $20 million in the first half included investments in our new Florida distribution center, IT system upgrades including new financial systems and productivity projects like more efficient lighting in our distribution centers. Our capital spending was front-end loaded this year due to these key projects and we still expect to spend about $30 million this year.

We did not repurchase shares during the second quarter, which means so far this year we bought back nearly 1.2 million shares for about $68 million. About $100 million remained on our current authorization. Our balance sheet remains strong with debt EBITDA leverage at about 2.7 times at the end of the second quarter, slightly above our objective of 2.5.

Looking forward, while market conditions remain challenging, we are managing with a disciplined approach to expenses and working capital while investing for the future and driving profitable growth. July sales are trending in line with our June year-to-date sales growth rate. Growth rates in office products, technology and furniture categories remain under pressure. Fortunately we are seeing continuing strong growth in our janitorial/breakroom category and ORS Nasco.

Our gross margin for the rest of 2008 may continue to reflect pressures from a lower margin product mix, higher fuel cost and a competitive pricing environment. We will work diligently to offset these with WOW initiatives and expect further benefits from actions we have taken to mitigate the impact of higher fuel cost.

With respect to supplier allowances, product receipts should track closely with sales for the balance of the year. So allowances should track with sales and the mix of sales. Gross margin should also benefit from inventory cost adjustments due to higher product cost inflation, since many suppliers have announced price increases that will take effect in the third and fourth quarters. We will take an opportunistic but cautious approach to investment buy opportunities.

Relative to operating expenses, our short-term spending controls combined with our ongoing WOW programs should enable us to hold second half expenses as a percent of sales in line with second half 2007 levels, excluding the impact of ORS Nasco. Achieving this goal will be challenging given the impact of general cost inflation and the leveraging effects of lower office products volume.

In addition, we will continue to invest in mission critical areas like IT and marketing upgrades. The second half will benefit from a reduction in facility move project activities, which we estimate had an incremental cost impact on the second quarter of more than $1 million. We will also continue our disciplined management of working capital and expect our free cash flow to exceed $100 million for 2008. This anticipates approximately $30 million of capital spending and depreciation and amortization of about $45 million.

Our continuing success in working capital efficiency improvements should enable us to hold our year-over-year working capital investment about flat including ORS Nasco. We will take a carefully measured approach to utilize our free cash flow to return value to shareholders while optimizing our capital structure by balancing investment buys with both on acquisitions and share repurchases.

We will aim to stay close to our targeted debt leverage of approximately 2.5 times EBITDA. In summary, we are actively managing all aspects of our business to maximize earnings and cash flow performance this year while positioning ourselves for even stronger performance when the economy improves. Now I’ll turn the call back to Dick.

Dick Gochnauer

Thank you, Vicky. Now I will add some background to Vicky’s presentation of our quarterly sales focusing first on revenues by type of customer and then by-product category. Sales to independent resellers which include sales to our United Stationers supply, Lagasse and ORS resellers as well as new channel customers contributed about 84% of our total revenues and were up 12.2% for the quarter. Excluding ORS Nasco sales were up 3.6%. Our independent office product retailers appear to be holding their own in this tough environment.

Many of our larger dealers and internet based resellers actually are posting strong sales gains. Our new channel customers are still a source of double digit sales expansion. Growth here comes from adding more customers and increasing sales with current ones. One measure of our success here is that we have a relationship with six of the top ten internet e-retailers in the market today. Switching to national accounts, they contributed over 16% of our revenues. Sales were down 1.4% from the same quarter last year. This is better than the 11% decrease we experienced in the first quarter of this year. You already know the limiting factors here.

The slow economy, the office furniture that represents a significant portion of our business to do with the nationals and this category weakened in a slow economy. And nationals continue to focus on their internal supply chains. We continued to enhance our value proposition to the national accounts. For example, they are increasing the amount of janitorial and breakroom supplies they buy from us. These products offer two challenges for the nationals. They are high cubed so they take up a lot of space in the warehouse and there are a large number of skews in this category.

By leveraging United breadth and depth of inventory national accounts do not have to stock the products in this category. We anticipate growth will continue in the janitorial and breakroom which will help offset declining sales in other categories. Now let’s take a look at sales by-product category. Sales of the janitorial and breakroom supplies expanded 14.4% during the quarter and contributed over 21% of our total sales. There are four reasons for this category expansion during the quarter. First, of our roughly $23 billion U.S. market produced products, only 20% go through wholesale distribution.

We are doing a good job of convincing retailers who traditionally made direct purchases from manufacturers that is more cost effective for them to work with us. For the reasons I just mentioned, for the national accounts. There are plenty of opportunities for us to gain market share for the years to come. Second, we continue to introduce janitorial and breakroom products to dealers and distributors that are not traditionally, haven’t offered these products as a full category. We are seeing particular success with the office products dealers through our office jam program and industrial distributors through the combined efforts of Lagasse and ORS Nasco.

Third, we successfully began servicing major pieces of new business which we gained towards the end of 2007 and fourth, manufacturers are increasing their business with us. They choose to avoid the high fuel costs, realize efficiency and improve service by turning over to us some of their customers they had previously served directly. Our technology products category contributed 34% of our revenues for the quarter. Sales were flat compared to the prior year. Thee Technology Supplier’s report that in consumers are focusing on the basic supplies such and ink and toner cartridges and postponing discretionary purchases of the bigger ticket items which typically offer higher margins for us.

Competition on the consumables has also intensified. Despite market dynamics we are maintaining our market share with major suppliers. There are three examples of how we are doing this. United and their major supplier provided training to a group of dealers that focus on selling printers and printing technology to help them increase their success in reaching the rapidly evolving small to medium-sized business or SMB, office printing market and to increase their in consumers interest in managed print services.

We also launched growth incentives that should help drive sales in the second half. Second, we continue to improve our smart deals, monthly flier and expand its reach into the SMB market. We also launched a new monthly hot deals program that focuses on creating opportunistic sales of new and [End-of-Life] technology products.

Finally, we continue to strengthen our operational platform to better serve this complex fast moving category. We improved our serial number tracking capabilities, which is crucial to support printer hardware sales then also increasing efficiency by focusing on printer hardware and data storage inventory into fewer facilities, but adding depth of availability.

Office furniture contributed almost 10% of our total revenues for the quarter. While sales were down 8% from last year’s second quarter, this performance was slightly better than the first quarter. Most of our business comes from transactional furniture sales to the SMB and small office, home office or SOHO markets.

The soft economy seems to have taken a greater toll on smaller companies than on the larger firms, so they are holding back on discretionary purchases like furniture. However, sales of our value priced private label brand are still growing at a double-digit rate. And our value-added furniture set in delivery and safe planning and design services continue to be in demand, supporting our resellers with end-to-end product and service solutions.

Sales of our traditional office products represented 27% of United’s total sales, and we are up 1.3% from last year’s second quarter. The trends here include a shift to lower cost value oriented products and increasing demand for our private label United brands. We are working closely with our supplier to focus on marketing programs to stimulate demand, including promotions like our monthly smart deals and back-to-school programs.

Now on to industrial supplies which are sold by our ORS Nasco. This category represented about 6% of our total sales. ORS Nasco had a strong second quarter and remained on track to reach our 8% to 10% revenue growth target for 2008. The increases are coming from two areas. First, we continue to expand our market share. Recent surveys indicated that only 60% of the 150,000 industrial distributors in this segment purchase through wholesalers, and the amount they spend is historically very low.

Just as with our janitorial and breakroom category, we are reaching those and have been stocking products themselves and explaining the value they can see by working with us. Our growth is coming from expanding our share of wallet with the current distributor customers as well as significant growth with smaller and new customers. Second, we are seeing sizeable growth in the safety-related products. Not only among ORS Nasco’s traditional resellers but from some of our other customers as well.

Now that you had a good feel for our sales, let’s talk about what happened with our value drivers during the quarter. Our first value driver is to deliver profitable sales growth. I’ve already talked about the growth in our janitorial and breakroom and industrial supply categories. Combined, these represented over 27% of our total revenues. We believe these areas will continue to grow at a strong pace and provide profitable sales.

In addition, we have a number of sales growth teams focused on specific opportunities. Here are two initiatives they are leading. First, we are targeting the public sector and schools. There is a growing desire by government agencies and schools to purchase office supplies from small businesses and local business partners. We are developing programs to help resellers capture their fair share of this business.

Second, we are selling green. Consumers had never been more interested in sustainability practices and using more green products. We recently launched an initiative designed to deliver green solutions to the SMB markets. Our green catalog of over 2,500 products is already gaining traction with resellers and we are developing additional tools.

Our second value driver is to drive out waste. Our war on waste or WOW squared program is about removing $100 million of expenses from 2007 through 2011 while improving the customer experience and our internal processes. Most of our efforts in the quarter focused on offsetting fuel cost inflation and improving quality while reducing expenses at our distribution centers. Here are some examples.

We continue to expand our Six Sigma and lean management efforts in our field operations. As a result, we are improving processes and increasing warehouse productivity. In a related move, we are reducing the cost of floor quality. In the last year we invested in a master database that includes the weights and dimensions of all of our products. Now we are using it as part of our weight checking program in nine facilities.

To date we have prevented over 25,000 instances where the wrong product would have been shipped to our partners, saving them and to us not only significant dollars but also wasted time. Continue to find opportunities to maximize the effective use of square footage among our three businesses. At Stationers Supply, Lagasse and ORS Nasco. As a result, we were able to ship capacity between these businesses and reduce expenses in Nashville, Minneapolis and Florida markets.

Maximizing our transportation and freight services is yielding savings for us. We adjusted our delivery rates to reflect the higher cost of service to smaller fleet accounts. We continue to improve our fleet fuel efficiency by using engine monitoring technology, which reduces the idle time and other non-value fuel consumptions. We also are successfully leveraging our carrier network across supply, Lagasse and ORS to maximize volume discounts.

We are seeing success with our newly introduced carrier network called (inaudible). This program was developed to reduce transportation costs for the reseller while improving service for to the end consumer. That extra is a hybrid drop shift delivery service consisting of UPS and a proprietary list of courier agents. This program is supported by enhanced routing technology which seeks to optimal use both UPS and courier based on the shipping characteristics of each order. Orders to become more green as a company are also yielding savings. Today we have retrofitted lighting at 17 of our larger facilities so far and we expect to save over $1 million in energy costs each year as a result.

We also implement a conveyor energy management in two facilities which automatically shuts the conveyor systems off when they are not in use and are in the process of installing it in two more places. The third value driver is to expand our United private brands. Our efforts during the quarter resulted in 6% higher sales and led these brands to contribute more than 13% of our revenues. I frequently mention the increases we see here are driven by end consumers looking for value-priced products. This trend should continue as manufacturing input costs across almost all of our product categories, raw materials, energy, etcetera, continue to escalate.

Our Alera line of feeding and taste goods as well as various janitorial and breakroom private brands were particular bright spots for us this quarter showing over 18% and 16% growth respectively for the first half. We believe our private brands have plenty of room to grow especially through our Office Jan program. Our fourth value driver is to optimize United’s assets. As you saw from our inventory turnover gains our inventory teams and replenishment systems react quickly to demand changes. This allows us to maintain high service levels while generating strong cash flow even with slower sales growth.

With that said here is our philosophy for investing in our business for the rest of this year. We will focus our capital spending on IT and facilities-related projects that will generate a strong return for us. When it comes to inventory we will continue to make opportunistic investment buys. Many suppliers have announced price increases in the third and fourth quarters so we will be purchasing inventory in advance when this creates an attractive return for us. And as always, uses of our free cash flow may include share repurchases as well as potential bolt on acquisitions.

We will take these actions as they make the most sense while maintaining our targeted debt leverage. Our fifth value driver is to unlock the value from acquisitions. As you know, ORS Nasco is on track to meet its 2008 revenue and profit goals. Just as important is the steady progress we are making to capitalize on the opportunities among the three businesses. Here are a few efforts across business unit teams are working on. First, in the month ahead we expect to launch a broader janitorial and breakroom offering through ORS Nasco replicating the success we have had it with it our office initiative in the office products channel.

Second, operational and logistics teams are looking for ways to use existing United and Lagasse infrastructure to cost effectively expand ORS Nasco’s market and service proposition. Finally, we have made steady progress in key energy areas including freight costs and joint supplier programs and business-related expenses such as insurance and other professional services. Our sixth value driver is to use technology to enhance our marketing capabilities.

We have focused on three areas, first, creating one unified database of all of our product information which we will call our digital content management. Second, developing a searchable online catalog that can be imbedded into any e-commerce store for an application used by independent dealers. And third, working with third party software providers including SAP to enhance their e-commerce and back office solutions. This will enable dealers to remove costs from their operations while providing end consumers with an excellent shopping experience.

Here is that progress report on these areas. We believe that our content management system is now the best in our industry. Includes photos, sales copy, detailed product descriptions and product cross sale and upscale suggestions. Objective is to enter all of the content just once then use it in multiple applications. The second quarter United database was used for the first time to create our 2009 general online catalog. Having all the information in one place rather than having to search for it or take new photos allowed us to push back production deadlines so that we had the most current information and saved considerable cost. This capability also is allowing us to increase the frequency of touch points between dealers and their end consumers.

We now have two publications available each month rather than our traditional approach of creating catalogs and flyers quarterly. As you saw from our news release and heard from Vicky, we took a $6.7 million asset impairment charge for capitalized software development related to SAP’s RTS project. As a result of delays in bringing the SAP solution to market and as other software solution providers have begun to work on similar programs it became clear that to have the greatest impact we needed to provide our e-catalogue technology and superior digital content to everyone.

We are still committed to the SAP solution and to other top-tier third party providers to ensure the dealers have the best possible solutions. We are encouraged by recent progress on RTS as well as by other software solutions and expect that to start seeing benefits of these efforts later this year. Now that you have a solid understanding of our second quarter, here is a preview of what we see for the rest of the year.

While the economic climate remains uncertain, what we do know is that our broad product line of carrier logistics, effective marketing programs and excellent training capabilities, will continue to add value and be valued by companies that want to prosper in this market. And United will prosper itself by continuing to find new opportunities for profitable growth in our product categories and customer channels, aggressively managing our costs while continuing to improve our processes and maintain high level of customer service; improving working capital efficiency, deliver strong cash flow and balancing the need to invest in our future while delivering results today.

I want to thank our entire United team for all their efforts under difficult circumstances. We’re sure to have some questions at this point.

Question-and-Answer Session

Operator

And ladies and gentlemen at this time we will conduct a question-and-answer question. (Operator Instructions). And our first question comes from the line of Dan Binder from Jefferies & Company. Please go ahead.

Dan Binder - Jefferies & Company

Hi, good morning.

Dick Gochnauer

Good morning, Dan.

Dan Binder - Jefferies & Company

You guys had a nice bounce back this quarter after Q1.

Dick Gochnauer

Thank you.

Dan Binder - Jefferies & Company

Congratulations. Question for you is as you look forward over the next couple of quarters, a lot of the good work that you’ve done to drive top line in a tough environment has been working well. But the employment picture is getting worse and I’m just curious, seems like you’ll have to run twice as fast in the back half of the year to keep up the pace. So, one, I don’t know if you would be interested in sort of giving us a rough idea of what you’re expecting in the back half and two, how you get there?

Dick Gochnauer

Okay. Well of course that’s the $64 question we are all asking ourselves, as we are watching the same kind of employment trend numbers. Although, it seems to be leveling off at the moment but don’t know where it it’s going to go from here. Clearly, we saw the improvement in the second quarter. Part of it was a shift as we know from the first quarter and the timing of the Easter holiday. And as we indicated, July is kind of running along the rate, if you take really the first half of the year.

So to some extent we don’t know whether to say, hey, things have leveled off or we have some more deterioration in fronts of us. So I guess your guess is pretty much as good as ours on that question. The good news for is us is we are seeing good growth in the JanSan area and industrial area and the new channels and some of the new initiatives we have done. And so, some of those are really independent. The success in those areas are really independent of the economy. And as a result of that, aren’t going to be as affected I think by what happens in the employment numbers. So those give us some cause for optimism at this point. But figuring out the rest of it is what we’re all trying to do.

Dan Binder - Jefferies & Company

Were there any customer incentive programs at the end of Q2 to drive some business ahead of the Q3 price increases that may reverse as we get further into Q3?

Dick Gochnauer

No.

Dan Binder - Jefferies & Company

Okay. And then, you mentioned Vicky that the pace of inventory ordering should be in line with sales. I guess, keeping in mind that there are price increases coming through and it sounds like you’re going to take advantage of some buyings, I guess I’m a little bit confused how you do that, how you keep a similar pace of inventory growth with sales if you’re doing the buyings at, what would presumably be a faster rate.

Vicky Reich

Great. Dan, the buyings are really just timing issues. Generally there are weeks of inventory. It’s certainly not something that extends us over a longer period of time.

Dan Binder - Jefferies & Company

Okay. And then just to be clear on the message on SG&A. I know that the original plan was -- I believe the original plan ex-Nasco was to keep SG&A dollars roughly flat year-over-year. I think you said it might be a little bit tougher with some of the cost inflation that you’re seeing in running the business. Two things on that. Could you give us, outside of fuel where your other sources of pressure are on expenses and with that in mind should we be thinking about expense dollars being a little bit higher for modeling purposes?

Vicky Reich

Well, we think in the back half of the year we’ll be able to hold expenses as a percent of sales, roughly flat with the year ago. In terms of where we are seeing inflation, nothing beyond fuel costs. Compensation and other costs are really running at sort of normal historic inflation rates. The challenge for us has been really in the office supplies business, where our growth rate has been less than that inflation rate, so running hard to keep up with that.

I would also say in terms of the second half spending that when you compare to the second quarter, we did have some incremental costs over a million dollars related to facility moves in the second quarter that should not repeat. Certainly not to that magnitude in the second half.

Dan Binder - Jefferies & Company

Okay. And then with the cost cutting program programs in place I think you did quite a bit of work right after it became clear that Q1 was going to miss and re-bounce back nicely for Q2. If we sort of thought about it in innings, are we kind of in the middle innings of the cost cutting for the year or did you get a lot of that done already in Q2?

Dick Gochnauer

Our WOW programs kicking throughout the full year. So you keep seeing the impact of those as the year progresses. I would say that a lot of the overhead efforts, freeze on hiring, some efforts to control spending and some other additional efforts as a result of Q1 really should have a bigger impact in the second half than they have so far. It just takes awhile to get the impact of that to drop down. So we are hopeful that all those efforts, our WOW initiatives will allow us to do what Vicky just described which is maybe not make the progress we would like to see in terms of total expenses as a percentage of sales going down, but at least trying to hold the line.

Cody Phipps

It is Cody. We are constantly looking for new opportunities to launch additional WOW projects. So I guess using your analogy we are probably in the middle innings but still looking for hits and doubles and singles.

Dan Binder - Jefferies & Company

Okay and then last question on staples. I realize they are still early on in figuring out what they need to do in their integration. Any new developments or news from them in terms of what, how they see their business with you guys trending over the next six months or so?

Cody Phipps

I think we continue to stay very close to them. They have formed and launched about 13 integration teams. We are working closely with them. We don’t anticipate any significant impact on our business with them this year. But we are staying close to them and as a good partner we are trying to figure out ways we can help them through that integration and we believe there is a role for the wholesaler in that process.

Dan Binder - Jefferies & Company

Great. Thanks.

Dick Gochnauer

No major impact this year.

Dan Binder - Jefferies & Company

Thanks.

Operator

Thank you. Our next question comes from the line of Jonathan Lichter from Sidoti & Company, please go ahead.

Jonathan Lichter - Sidoti & Company

Good morning.

Dick Gochnauer

Good morning Jonathan.

Jonathan Lichter - Sidoti & Company

How much of the sales gain was caused by the Easter shift? Can you give any metrics there?

Vicky Reich

Good morning. It is an inexact science but our best estimate would be it was about 1.5 of growth that shifted from the first quarter into the second quarter as a result of the Easter timing shift.

Jonathan Lichter - Sidoti & Company

And do you expect to see that product inflation equally in Q3 and Q4 or more so in Q4?

Vicky Reich

That’s hard to say. At this stage I would say it is probably equal although what we don’t know is there will likely still be some inflation that comes true later in the year that we are not yet aware of. So the fourth quarter couldn’t accelerate a little bit more based on trends we are seeing.

Dick Gochnauer

Typically a fourth quarter inflation would not affect our bottom line until the following quarter so because we have to pass it on, etcetera. And so the price increases that have occurred in the end of the second quarter and we expect to occur at the end of the third quarter will have an impact this year.

Jonathan Lichter - Sidoti & Company

And at what point would you feel comfortable again doing buy backs?

Vicky Reich

Well, you know, our debt-to-EBITDA is about 2.7 so close to our target. So our aim is through good management of cash flow in the back half and generating EBITDA to create some capacity. As you know we have an authorization the board put in place recently for $100 million. So it is really a timing issue as to when we can create that capacity. And then the alternative uses that we will need to balance between the short term uses investment buy opportunities, potential bolt on acquisitions and the share repurchases. What I would say is we absolutely remain committed to share repurchases as a vehicle to return value to shareholders.

Jonathan Lichter - Sidoti & Company

Thank you.

Operator

Thank you. Our next question comes from the line of Rob Damron from 21st Century Equities. Go ahead.

Rob Damron - 21st Century Equities

Good morning. Congratulations on a nice sequential improvement on the numbers.

Dick Gochnauer

Thank you.

Rob Damron - 21st Century Equities

Wanted to talk a little bit more about the electronic catalog technology. What are the plans there in terms of additional investments going forward and maybe you could describe for us again the business model surrounding that if you have third party software providers would you be re-selling their software or I guess basically how does that work? Is there a revenue opportunity there in terms of selling software?

Dick Gochnauer

Good questions. Let me start with the second question and I will come back to the first one. No, we will not step in and become a software seller ourselves. That’s why we partner with these third party providers including people like SAP. And they will, in fact, or their partners will be the ones who sell and service the software with our dealers. Our interest, quite frankly, is trying to ensure that our dealer customers have world class software, both back office and then front office, which is really their e-commerce front end to their customers so that they can compete effectively in the marketplace. And they right now are handicapped because they don’t have good content and they don’t have good search and they don’t have effective merchandising delivered via the web. And so, these investments are all designed to enable that to occur which we believe will do a number of things for us.

We think we’ll sell more products. As a result, we think we can deliver more marketing campaigns in cooperation with our dealers, on behalf of our manufacturers to end consumers, which I think will benefit everyone in the chain and we think that these investments will actually take cost out of the supply chain. We are pretty sure of that for everyone.

So those are the three driving reasons why we want to do it. We don’t make the investments in the content for example that we’ve been making and into our smart search digital catalog and in the investments to support the third party. We haven’t done that to be in the software business, we have done that for the reasons I just described.

To answer your question on investments, we made a big investment which we disclosed in 2005 and 2006 and that’s what we just described. In the RTS technology to get that launched, SAP basically has been running with the project. Since then, it is a kind of center to their overall strategy I would say from my perspective, as well as all software companies are really looking to put out in the marketplace products which are called software as a service, which is getting away from just selling and licensing software itself.

And in effect, the technology SAP is building here to go out to the dealers with, is based on their base technology R3 and designed in such a way to in effect accomplish that objective. So it is kind of leading edge stuff. It’s taking a little, taking I think them a lot longer than us, our perception longer than we had originally anticipated. But, quite frankly, it’s the right direction I think for software companies and I think you will see more companies trying to accomplish what SAP is trying to do here.

Rob Damron - 21st Century Equities

Great. I mean it certainly sounds that the benefits are real to everyone in the channel. Why do you think that it has taken longer to roll this out into the channel than first anticipated?

Dick Gochnauer

Well, it is basically trying to design what is called the hosted solutions, which means that, a very complex software capability is essentially hosted and you essentially sell the service to dealers and they don’t have to have their own IT group, they don’t have to have their own capabilities. And that is a trickier component than the traditional approach. And as I say, not just SAP but most software companies are trying to figure out how to do that because I think that’s the future and I think most people believe that’s the future of computing. And so, we’re kind of at little bit of the bleeding edge of that development of that capability. But, SAP and others seem to be committed to get there and the good news I guess is it’s built on a really solid base platform, which I should set them well going forward.

Cody Phipps

Robert, its Cody Phipps. I’ll just add to that. One of the strengths of our dealers is the very models that they have. There is no one model that leads to success. And so that’s a complicating factor in getting all the functionality right in a tool like that. Not an execution but just a feature of the folks we do business with.

Rob Damron - 21st Century Equities

Okay. And then just one last unrelated question just with regard to acquisitions. Maybe just talk a bit about the acquisition environment out there. Multiples of current acquisition, opportunities that you may be seeing and are you still pursuing kind of a diversification strategy into other areas like your most recent acquisition into the industrial space?

Cody Phipps

Well, to answer your question, there is probably better people to answer than me. But clearly, the larger the deal I’d say the more pressure there has been on the multiples, because of difficulties with tight credit and financing and so you have seen those come down. The smaller deals are less affected I think by the tight credit situation and so may not be as affected by what we are in right now. But there are fewer people out there -- appears to be fewer people out there trying to fish.

With regard to our objectives, we continue to say that our use of cash will be two primary uses. One is to obviously increase shareholder value. One of which is to buy shares back and second is to where appropriate to invest in what we call [bocklin] acquisitions. But we only want to do those if we see them to be accretive in a fairly short period of time and fit our strategy. And so, we are currently selective. You can see we’re not an acquisition machine. We do it only when it makes sense and we tend to want to absorb the ones that we’ve done and make sure we understand the business and do all that before we rush off and do more. And I think that would be the pattern, at least historical pattern of this company and I would suspect you would see that going forward.

Rob Damron - 21st Century Equities

Okay. That’s helpful. Thank you.

Operator

Thank you. (Operator Instructions). Our next question comes from the line of Dan Binder from Jefferries & Company.

Dan Binder - Jefferries & Company

Just a couple of follow-ups. On the vendor allowances you have disclosed more than you have in the past which is great. I was wondering if you could give us an idea within that third of your tiered vendor relationships or arrangements, what types of, is there a specific type of product that falls in that kind of arrangement? Is it furniture, heavily weighted furniture or supplies or tech or is it pretty much across the range?

Vicky Reich

I would say it is pretty much across the range, really not any particular type of category or supplier.

Dan Binder - Jefferries & Company

And if you were to look last year what portion of that third were you able to achieve higher volume rebates on? In other words, I’m assuming there are different levels based on the inventory ordering you are doing. Were you able to achieve higher rebate levels in half of the third tiered categories or was it a bigger portion and what should we expect this year?

Dick Gochnauer

Well, one of the things, Dan, is that each year we renegotiate our agreements and those take several months and in fact we still are in the process, which is fairly typical and so in that you kind of set the bar and reset the bar based upon the economic situation and your past history, etcetera. So just because we may have missed a volume tier last year with a supplier on a particular product doesn’t mean that we will necessarily miss it this year. So that makes it a little harder to do what you’re trying to do, and we love to do, which is kind of anticipate those, but clearly in a year in which volumes are under pressure, that puts pressure on some of those tiers. But what we are really trying to indicate is they are not as big an impact to the overall allowance program as I think maybe people had anticipated or perhaps even been in the past.

Cody Phipps

I would just say we are constantly working with them to enhance our programs and to find opportunities between us and the suppliers. So it is an ongoing. We had major suppliers in yesterday talking to them. So I don’t know quite how to give you a forward-looking view of that, Dan.

Dick Gochnuer

The other factor that comes in is the fact that because these are supplier by supplier sometimes there are shifts between one supplier and another supplier in the marketplace. May be that one supplier we’ve got a more effective marketing program with than another and they grow faster than their competitor. As a result we hit their volumes tier. We didn’t hit their competitor’s volume tier if they had any and even though the category may not have been up we might have hit our volume tiers with one of the two suppliers. So that again makes it a little difficult to anticipate.

Dan Binder - Jefferries & Company

I was just essentially trying to figure out what percentage you exceeded volume tiers but it sounds like it is not really relevant when you look at it, against two different years. With that in mind, what percentage of these tiered negotiations or vendor negotiations have been completed so that you do have visibility at this point on what that looks like.

Dick Gochnuer

We, as I mentioned in discussions, we measure that two ways. One is when we finally get a signed document which is sometimes several months after we have actually negotiated an agreement. Okay. So that’s the most conservative way to look at it. If you did it on that basis we are only about halfway there in terms of signed agreements. If you look at it in terms of completed the negotiations, it is a higher number than that. And it is not too untypical where we normally are at this time of year. So what ends up happening is by the time the other 20% or 30% or 40% get negotiated in the second half, and finalized, then you know what the numbers are and in the fourth quarter you end up doing a true-up for any of the enhanced program that we were able to negotiate and that’s why you always see a little bit of a stronger fourth quarter impact on supplier allowances than you do throughout the year.

Dan Binder - Jefferries & Company

Now, are the other two thirds of the vendor arrangements that you have, are they tied to a fixed rate no matter what the volumes are or are there some thresholds on those that are just deeper, let’s say, if you’re within a 5 point band on your growth rate you’re going to get X-rayed but ifs severe one way or the other you get penalized or awarded. Is that the case of the other two thirds or that’s just a fixed number to that?

Vicky Reich

No, that would be, the tiers that we spoke of would be what you’re talking about. But on the other two thirds it is a rate, a negotiated fixed rate that applies to purchases of a particular product.

Dick Gochnuer

Right. So it would be affected by volume. So if you bought a little less then we would earn a little less and vice versa. And it simply stays the same.

Dan Binder - Jefferries & Company

At this point in dollar terms do you think vendor rebates will be in line with where they were last year?

Dick Gochnuer

It’s hard to say. It really is. It depends where the mix comes. The challenge we’ve got and as we mentioned to you the higher rebates tend to go with the higher margin products and some of those are discretionary products and like furniture and so those are more challenged this year than in the past. So that puts downward pressure on the total number and so if you did nothing else and just understand that you would say the total dollar pool would be less if those are all the circumstances you had. Then offsetting that, of course, are our efforts to sell the right mix of products, the ones that give us higher allowances to work with vendors to get the volume up where we make the biggest dollars and clearly any enhanced deals that we are able to negotiate. So you’ve got kind of those combinations but pretty much on their own if you just take the economic climate that put’s a challenge on the total dollar amount.

Dan Binder - Jefferries & Company

Okay great and then just for clarification. Your previous comments about the systems and investments that you’ve made, the interim fixes that you’re doing until the SAP product is fully ready to go, are there additional expenditures tied to that of any significance?

Dick Gochnuer

Yes, all of the investments we were making in from the digital content to the smart search technology to the support for the PVs including the RTS project are all included in our capital or expense budgets. So, yes, we are investing but it is kind of within the scope of normalcy for us. We have shifted money around to be able to support these kind of initiatives but it is not like a huge investment project for us. We wouldn’t be able to deliver the 30 some million dollar capital target.

Dan Binder - Jefferries & Company

Great, thanks.

Dick Gochnuer

Okay.

Operator

Thank you. Our next question comes from the line of Simon Porter from First Manhattan. Please go ahead.

Simon Porter - First Manhattan

Good morning. Great execution guys in a very tough environment.

Dick Gochnuer

Thank you.

Simon Porter - First Manhattan

Dick, I was wondering if you might be able to go into a little bit more detail on the net extra program. Is this a career group that USTR has put together or you’re using some other service that has this network already out there? And to talk about the freight savings you’re managing to offset, how much did that contribute to that get back versus any surcharges you might have put on?

Cody Phipps

Simon, it is Cody Phipps.

Simon Porter - First Manhattan

Hi, Cody.

Cody Phipps

The net extra network we are very excited about. That it is a combination of an internal team and we did partner with an outside technology firm and so what we’ve done is we are knitting together couriers across the country with UPS-like capability in terms of package tracking, proof of delivery; customer service feedback and we piloted it for a long. It’s been a long time in the build. We are now rolling that out to dealers getting very good feedback and what it has done is given us the ability to optimize routing to the lowest cost delivery method. It is not a replacement for UPS or FedEx but allows us to take certain products and orders and ship them to a lower cost courier network. We are excited about it. It is a new service to our dealers and it is part of our portfolio of freight offerings. I would tell you the way we are able to offset some of the increases in transportation is we are shifting smaller orders or harder to deliver orders to that courier network where we can deliver for a lower cost. I don’t know the exact percentage of it but ifs a significant effort on our part and we see it as a significant savings tool in our overall efforts to combat rising fuel and freight costs.

Dick Gochnuer

Simon, we did do a fuel surcharge increase in June. The industry did it as well. And that is a small part of the number. It is mostly cost saving initiatives that are driving. Cody mentioned one of them. But they have at least 15 or to so projects that are out there that are all affecting our ability to drive hold our costs down.

Simon Porter - First Manhattan

That’s terrific. Thanks a lot. Keep it up.

Cody Phipps

Okay.

Operator

Thank you. I’m showing we have no further questions at this time. I’ll turn it back to management for any closing remarks.

Dick Gochnuer

Thank you. If that could summarize the quarter I would say that executing our business plan and the commitment to our six value drivers helped it to show improvements in sales, EPS and operations in a difficult market. I think you can clearly see the results of our having created a diversified base of business. By expanding into the janitorial and breakroom supplies and industrial products we were able to offer a variety of products and services to the emerging markets. The same time we are diversifying our sources of growth while offering new growth opportunities to a broad base of reseller customers. Vicky, Cody and I want to thank you for joining us and you will be hearing from us again at the end of the October when we provide you a look into our third quarter results.

Operator

And ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may now disconnect.

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Source: United Stationers Inc. Q2 2008 Earnings Call

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