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OfficeMax Incorporated (NYSE:OMX)

Q3 2012 Earnings Call

November 06, 2012 10:00 am ET

Executives

Michael Steele

Ravichandra K. Saligram - Chief Executive Officer, President and Director

Bruce H. Besanko - Chief Administrative Officer, Chief Financial Officer and Executive Vice President

John C. Kenning - Executive Vice President and President of The Contract Business

Michael J. Lewis - Executive Vice President and President of Retail

Ronald Lalla - Former Chief Merchandising Officer and Executive Vice President

Analysts

Michael Lasser - UBS Investment Bank, Research Division

Oliver Wintermantel - ISI Group Inc., Research Division

Christopher Horvers - JP Morgan Chase & Co, Research Division

Gregory S. Melich - ISI Group Inc., Research Division

Bonanza Chalaban - KeyBanc Capital Markets Inc., Research Division

Alan M. Rifkin - Barclays Capital, Research Division

Anthony C. Chukumba - BB&T Capital Markets, Research Division

R. Scott Tilghman - Caris & Company, Inc., Research Division

Operator

Good morning. My name is Sarah, and I will be your conference call facilitator today. At this time, I would like to welcome everyone to the OfficeMax Third Quarter 2012 Earnings Conference Call. [Operator Instructions] It is now my pleasure to introduce you to Mike Steele, Senior Director of Investor Relations of OfficeMax. Mr. Steele, you may begin your conference.

Michael Steele

Good morning. Thanks for joining us. Today's call will be archived in our website for 1 year and is available as both a webcast and a podcast. Certain statements made on this call and other written or oral statements made by or on behalf of the company constitute forward-looking statements within the meaning of the federal securities laws. Management believes that these forward-looking statements are reasonable. However, the company cannot guarantee that actual results will be consistent with the forward-looking statements, and you should not place undue reliance on them. These statements are based on current expectations and speak only as of the date they are made. The company undertakes no obligation to publicly update or revise any forward-looking statement. Important factors which may cause results to differ from expectations are included in the company's annual report on Form 10-K and in the company's other filings with the Securities and Exchange Commission. Now I'll turn the call over to our CEO, Ravi Saligram.

Ravichandra K. Saligram

Thanks, Mike. Good morning, everyone, and thank you for joining us. I'm pleased to report that we continued to make progress against our long-term goals, realizing our fifth consecutive quarter of year-over-year improvement in adjusted earnings per share. Specifically in the third quarter of 2012, adjusted EPS was up 8% versus prior year, and year-to-date 2012 adjusted EPS is up 38% versus a year ago. Given our goal of improving operating margins, our teams continue to strengthen core business fundamentals, which resulted in a third quarter improvement in company gross margin by 50 basis points and an increase in adjusted operating income margin of 30 basis points. Year-to-date 2012 adjusted operating income for the company is up 26%, and adjusted operating income margin is up 40 basis points versus the prior year. Our U.S. Contract business continues to show top and bottom line strength. The plans we put in place 18 months ago are taking hold, and the business is gaining traction. Our digital initiatives, which are part of the U.S. Contract business and include our officemax.com, solutions.com and reliable.com websites are progressing well, achieving profitable double-digit growth in both of third quarter and year-to-date.

Our international Contract business, which includes Canada, Australia and New Zealand remained a strong profit contributor. Both in the third quarter and year-to-date, our international operating profit increased significantly versus prior year. In the third quarter, our Retail business continued to experience significant challenges due to revenue shortfalls precipitated by steep declines in the technology sector and especially in personal computers. Softness in Retail sales, combined with weak international Contract sales, negatively affected the company's top line. In the third quarter, total company sales declined 1.7% on a reported basis or a 1.2% decline on an adjusted basis. Year-to-date, total company revenues on an adjusted basis are down 20 basis points versus prior year. Top line strength in the U.S. contract, including our digital initiatives and in Mexico, was offset by a decline in U.S. retail.

We also continued to proactively work on balance sheet-related matters. I'm pleased that the non-recourse Lehman-backed timber notes liability has finally been extinguished from our balance sheet. A good step forward in creating greater clarity for our investors, particularly in terms of balance sheet optics.

With the respect to Croxley, we're in the process of assessing whether there is third-party interest that achieves our value expectations. We're continuing to explore matters related to our balance sheet, including non-core assets such as Boise. Of course, the final outcome from explorations regarding all of these matters will be guided by whether such decisions drive appropriate value for our shareholders.

So here's what we plan to cover on the call. First, I'll share the highlights from the third quarter and update you on some of our key initiatives, then Bruce will walk through the financial details of the quarter. And then I'll make some concluding remarks and move to Q&A.

So let's turn to our Contract segment performance. We again experienced strong profitable growth in our U.S. Contract business where sales grew 3.9% in the third quarter versus the prior year. Our Contract team continues to grow the core business and gain traction within furniture and workspace, and within key growth adjacencies like facilities, products and services, where year-to-date, we have achieved double-digit growth. Our net winter loss metric was positive for the sixth quarter in a row, and we maintained a record high quarterly retention rate on 93%. Additionally we continue to make good progress with our SMB sales units, and we have now expanded operations into 10 markets. I'm also pleased to announce the name change of our U.S. Contract business to OfficeMax Workplace. Our new name better can raise our value proposition of working with a wide array of customers, including businesses, universities, hospitals, schools and local governments, and enabling them with innovative services and solutions that help them to work more efficiently and productively.

Our strong performance within the U.S. Contract business was offset by a 7.2% sales decline in local currency for the international contract business versus the prior year. In particular, weaker government spending in Australia placed pressure on our top line sales there as various governmental agencies took on austerity measures. However, our new management teams in Canada, Australia and new Zealand continue to streamline and reduce operating expenses. Australia and New Zealand combined remain the company's third largest business in both third quarter and year-to-date sales and profits. Further, these 2 countries combined had the highest operating margin of any business within the OfficeMax portfolio. Also, our Australia and New Zealand business combined with our North American operations and Lyreco's footprint in Europe and Asia provide a powerful network through which we serve our global customers. We continue to believe that international business is core to our strategy and remain focused on steering the business back to top line growth.

Overall, I remained pleased with the progress we're making in the Contract business globally. Third quarter segment income -- Contract segment income was $26.5 million, an increase of 14% versus the prior year period and segment income margin was 3% in the third quarter of 2012, a 40 basis point improvement from the third quarter of 2011. Year-to-date, Contract segment income was $79 million, an increase of 60% versus prior year, and segment income margin was 2.9%, a 110 basis point improvement over prior year.

Now moving on to our Retail business. Despite good execution by our Retail team, third quarter U.S. sales comp declined 2.6% due primarily to lower technology product category sales especially in PCs. Industrywide softness in the U.S. technology category overall, which included sharp declines within the PC category in particular significantly impacted total company sales. Overall, our tech comps were down high single-digits. Within tech, income turned our comp down low single-digits.

Counter to the weakness we experienced in technology, our core furniture and supplies categories had positive comps for the quarter, helped by gains in copy and student paper, desk supplies and writing instruments. During this back-to-school season, we offered our customers good values while protecting our margins and our core categories performed well. According to the 2012 NPD Back-To-School Monitor full season report which uses panel data, OfficeMax was the only office superstore to post season over season share growth during the back-to-school season on school supplies.

Our in-store services also performed well again in the third quarter. In-press print and document services comped positive, and we are pleased with the volume we are seeing with ctrlcenter, which is our in-store technology and computer support offering. Our associates continue to do a good job driving sales through these high-margin services as we emphasize them in our stores.

For the third quarter, our average ticket was higher than last year, driven primarily by increased minimum customer spends that were required to achieve preferred back-to-school customer savings. This is also a factor for increased gross margins for the quarter, along with being more judicious in our promotional cadence and benefiting from a sales mix shift from lower margin technology products.

Although our day-to-day retail execution has improved, we continue to face industrywide structural challenges. The economy is not giving us any tailwinds and small business formation is weak. Adding to these issues, we now face a sector weakness in technology. Consequently, we'll be more aggressive in driving 3 specific retail initiatives: first, we continue to execute our store network rationalization with urgency. Specifically, we have already closed 5.4 million square feet of store space and nearly 2 million on a net basis since the beginning of 2005. We'll also opened only 2 new stores in the U.S. in the last 13 quarters. Year-to-date in 2012, we've already closed 25 stores, which is more than all of last year. In the fourth quarter, we plan to close up to 20 additional stores, which brings the total for 2012 to up to 45 stores. This represents the highest number of store closures in any given year since 2006. In fact, our plan is to reduce our U.S. Retail total square footage by approximately 15% or approximately 3 million gross square feet from the beginning of 2012 through the end of 2015.

This reduction is an addition to the nearly 5 million gross square footage reduction from the beginning of 2005 through the end of 2011. In total, we will have closed approximately 8 million square feet from the beginning of 2005 through 2015 on a gross basis. These reductions are being achieved through a 3-pronged approach of closing unprofitable stores, relocating stores and downsizing stores to a smaller footprint.

Second, we continue to focus our innovation efforts, which include looking for new categories to replace declining ones in our stores. A particular emphasis is being placed on high-margin services to build on our strong foundation of ImPress print and document services and ctrlcenter. And in the first quarter of 2013, we plan to launch a few value-added services targeted to our small business customers. We also plan to open our first small format store prototype in early 2013.

Third, in order to address challenges in the technology sector and particularly in PCs, we have reset our go-to-market strategy for technology. We will narrow our focus even more sharply on the small business customer and provide an appropriate level of product selection while prudently managing inventory risk and enhancing profitability.

To this end, we are refining our assortments to address customer requirements for the consumption versus creation of information. Specifically, we are downsizing our PC assortment by more than half while adding popular tablet choices. We're also significantly increasing our training for store associates to enable them to provide solutions to our small business customers and increase attachment sales. We will not be able to solve our retail challenges overnight, however, we have the right plan, the right talent and the right level of determination needed to make the appropriate decisions on our store portfolio, which gives me confidence that over time, we will be able to get this business back on track.

On a positive note, our Retail business in Mexico continued to do well. We opened 3 stores in the third quarter and continued to see comp growth in Mexico on a local currency basis.

So let me now conclude with an update on our digital initiatives. Our digital initiatives remain bright spots within the Contract segment and a key driver of our important multichannel strategy. The digital team made significant progress on several fronts during the third quarter. Our digital, initiatives again, delivered double-digit sales growth in the third quarter for officemax.com, driven by increases in both traffic and sales conversion rate. We executed aggressively against our roadmaps this past quarter, driving several key digital releases.

On officemax.com, we successfully launched a new search engine that is enabling customers to shop faster, with more accurate search and recommendation results for a more convenient and productive online shopping experience. In the first month, as the search engine was phased in, officemax.com experienced increases in conversion rate, customer satisfaction around site navigation and average revenue per visit. We also recently launched a key multichannel initiative: Online store pickup, where customers can conveniently buy thousands of products on officemax.com and pick them up in our stores often the same day and without paying shipping fees. Early response to the program has been positive.

On our solutions.com B2B website, we are now 30 days into the launch of a new more user-friendly interface with early but very positive feedback from our B2B customers, and we're on track with plans to launch the new search engine on our solutions website in early 2013.

Within our reliable.com platform, we enhanced our core user experience with shopping cart improvements and the addition of key features that allow for greater personalization of the website experience and provides a platform for gaining insight into visitor behavior and increasing conversion rates. Our operational capabilities within the digital initiatives remain strong.

In September, officemax.com was ranked #1 for the third time this year in critical site performance on both Internet Explorer and Firefox by Compuware Gomez, a leading authority on website speed, performance and consistency monitoring. In fact, it's important to know that Compuware Gomez has consistently ranked officemax.com in the top 5 websites every month since April of this year.

At this point, I'll turn it over to Bruce for the financial review and outlook.

Bruce H. Besanko

Thanks, Ravi, and good morning, everyone. Let's begin by walking through the income statement highlights. Consolidated net sales in the third quarter of 2012 decreased 1.7% to $1.7 billion compared to the prior year period. Adjusted for currency translation, store closures and the shift in weeks for our U.S. businesses related to the 53rd week in 2011, the consolidated adjusted sales decline was 1.2% versus the prior year quarter.

Third quarter Contract segment sales were $880.9 million, a decrease of 0.3% compared to the third quarter of 2011. In our U.S. Contract business, which is approximately 70% of our Contract segment, sales increased 3.9% from the prior year's third quarter. In the third quarter, continued strong net new sales, that is, sales to new customers exceeding lost sales to former customers more than offset a 2.9% decline in sales to existing customers.

As Ravi mentioned, new sales were positive for the sixth consecutive quarter, and we maintained a record quarterly retention rate. In Q3, sales in our international Contract business decreased 8.9% in U.S. dollars or a decrease of 7.2% on a local currency basis compared to the third quarter of 2011. With a new sales leader for Canada now in place, the team is working to stem a decline in sales, and the Australian team continues to adjust to continuing declines in government purchases. Third quarter Retail segment sales decreased 3.1% to $863.7 million compared to the third quarter of 2011, reflecting fewer stores and a 2.1% decrease in same-store sales on a local currency basis. U.S. only retail same-store sales decreased 2.6%, driven by lower technology product category sales. Furniture, supplies and ImPress print and copy services had positive comps in Q3, which included the back-to-school selling season. Average ticket was higher despite significantly lower PC sales and transaction counts were lower.

Third quarter Mexico same-store sales increased 2.2% on a local currency basis but declined 9.2% in U.S. dollars. We opened 3 new stores in Mexico in the third quarter where we continue to believe that we have meaningful growth prospects. OfficeMax gross margin was 26.4% for the third quarter, an increase of 50 basis points compared with the prior year period. Contract segment gross margin increased 10 basis points in the third quarter, primarily reflecting lower occupancy expense. Retail segment gross margin increased 100 basis points for the third quarter, primarily due to a sales mix shift from the relatively lower margin technology category and lower occupancy and delivery expense. Adjusted total operating expense, which includes general and administrative expense increased to 23.8% of sales in the third quarter of 2012 compared to 23.6% in the prior year quarter but was nearly $3 million lower on an absolute dollar basis. Contract segment operating, selling and G&A expense was 19.8% of sales for the quarter, down from 20.1% in the third quarter of 2011. The improvement was primarily due to lower payroll expense due to reorganizations and facility closures in 2011, which was partially offset by higher incentive compensation expense. Remember that in 2011, we had minimal levels of incentive compensation expense.

Retail segment, operating, selling and G&A expense was 26.8% of sales in Q3 2012 compared to 25.8% in the third quarter of 2011. The increase was due primarily to planned higher advertising expense due to the Big Deals Price Perception campaign and higher incentive compensation expense. Adjusted operating income margin in the third quarter of 2012 increased to 2.6% from 2.3% in the prior year period, driven by the 40 basis point year-over-year improvement in the Contract segment.

As we mentioned in this morning's press release, Corporate and Other Segment operating expense was $9.3 million in the third quarter of 2012 compared to $10.5 million in the prior year period. The decrease was primarily due to lower pension expense. For the third quarter of 2012, we recorded adjusted net income of $23.6 million or $0.27 per diluted share compared to $21.5 million or $0.25 per diluted share in Q3 of last year. Please note that adjusted sales growth, adjusted operating income, adjusted net income and adjusted earnings per share are non-GAAP financial measures, which we reconciled to GAAP financial measures in our press release.

Now let's turn to the balance sheet. In the third quarter, the $735 million of non-recourse debt guaranteed by Lehman was legally extinguished. Removal of the Lehman-related debt resulted in a writeup in our equity book value of more than $400 million. At the end of the third quarter, we had cash and cash equivalents of $506 million and total debt, excluding the non-recourse timber securitization notes of $236 million. Please bear in mind that the total debt I mentioned excludes the $735 million of non-recourse debt shown on our GAAP balance sheet, which is guaranteed by Wells Fargo. As we've said in the past and as demonstrated by the recent extinguishment of the Lehman-backed liability from our balance sheet, due to the non-recourse nature of this debt, in order to reflect OfficeMax's obligations accurately, we as well as third parties such as the 2 major credit rating agencies exclude this debt from the calculation of various financial metrics and ratios used to assess the valuation of the company.

As Ravi mentioned, we remain in the midst of a comprehensive review of all aspects of our balance sheet. I'm pleased to report that as part of this effort, certain participants are legacy pension plans were offered lump-sum payouts this quarter, which will potentially lower the plan's liability and mitigate volatility in the level of funding. The eligible participants account for approximately 1 quarter of total plan liabilities. The actual amount of reduction in the plan liabilities will depend on the proportion of eligible participants who elect the lump-sum payments. Participants have until November 16 to elect for the lump-sum payment, and those that do elect will be paid by the end of 2012. The lump-sum payments will be paid from the pension plan assets and are expected to reduce the pension benefit obligation liability. This action will result in a one-time non-cash charge during the fourth quarter of 2012.

In summary, we're making good progress on our balance sheet analysis. Now turning to working capital, inventories at the end of Q3 were slightly lower versus levels at the end of the prior year period. Accounts receivable at the end of the third quarter were significantly lower than the prior year period, primarily due to a lower vendor receivables balance. Accounts payable at the end of the third quarter were $12 million lower than the prior year period, primarily reflecting the timing of certain purchases, partially offset by the impact of foreign currency translation.

Looking at cash flow, we generated $158 million of cash from operations in the first 9 months of 2012 compared to $79 million in the prior year period. The increase primarily reflects favorable working capital changes and higher earnings. As part of the working capital favorability, keep in mind that there was minimal payout of incentive compensation expense in the first 9 months of 2012, reflecting our 2011 performance. Incentive compensation cash payments totaled $8 million in the first 9 months of this year compared to $55 million in the first 9 months of 2011. Capital expenditures, which were funded by cash from operations, totaled $48 million in the first 9 months of 2012. This was primarily used for systems improvement related to our growth initiatives, software enhancement and infrastructure improvements, as well as 7 new stores in Mexico.

Now turning to our outlook. September sales results were weaker than we expected going into the month. The weakness was primarily driven by declining retail technology product sales, which continued through October. We remain focused on containing costs as we continue to struggle to grow the top line while continuing to invest in our key growth adjacencies.

So for the fourth quarter, we anticipate that total company sales will be approximately in line with to slightly lower than the fourth quarter of 2011, including the anticipated favorable impact of foreign currency translation and excluding the additional fiscal week in 2011, which generated $86 million of sales. Also note that we expect to discontinue reporting results of our Mexico operations 1 month in arrears and will consequently realize an incremental fiscal month of sales in the fourth quarter, which is included in the sales outlook. We also anticipate that for the fourth quarter of 2012, adjusted operating income margin will be slightly lower than the 1.7% rate for the prior year period due to the benefit of the profitable additional week in the fourth quarter of 2011.

With respect to consolidated gross margin, we expect a slightly higher gross margin rate for the fourth quarter compared to the 24.5% rate in the prior year period. We expect SG&A expense as a percentage of revenue to be slightly higher than the fourth quarter of 2011 due in part to incurring a minimal level of incentive compensation expense last year. For the full year 2012, we anticipate that total company sales for the year will be lower than the prior year, including the anticipated unfavorable impact of foreign currency translation and excluding the additional fiscal week in 2011, which generated $86 million of sales. Also, keep in mind that we've been taking a significant number of stores out of our U.S. network, which hurts our overall reported sales growth. Adjusted operating income margin for the full year 2012 is anticipated to be slightly higher than the 1.7% for the prior year despite the benefit of the profitable additional week in 2011.

With respect to consolidated gross margin, we expect a slightly higher rate for the full year as compared to the 25.4% rate for 2011, and we expect full year adjusted SG&A expense as a percentage of revenue to be approximately in line with last year, despite reporting minimal levels of incentive compensation expense in 2011. Our outlook also includes the following assumptions for the full year 2012: capital expenditures of approximately $70 million to $80 million, primarily related to investments in IT, eCommerce, infrastructure and maintenance; depreciation and amortization of approximately $70 million to $80 million; cash contributions to the frozen pension plans of approximately $21 million, $20 million of which was paid in the first 9 months of this year; pension expense of approximately $3 million, which excludes any non-cash expense related to the lump-sum payout initiative in Q4, any such non-cash expense will represent accelerated expense for those eligible participants who elect the payout that otherwise would have been amortized over their service lives; interest expense of approximately $70 million and interest income of approximately $44 million; an adjusted effective tax rate approximately in line with the adjusted effective tax rate in the full year of 2011; cash flow from operations exceeding capital expenditures with working capital expected to be a seasonal use of cash in Q4, additionally in Q4, we expect to make an approximately $15 million tax payment, representing the accelerated tax liability on the Lehman timber notes, mostly offset by tax credits; a net reduction in retail store count for the year without the 45 store closures and 1 store opening in the U.S; additionally, we expect a total of 8 to 10 store openings and 1 or 2 store closures in Mexico. As Ravi mentioned, we've been working to rightsize our U.S. retail square footage as demonstrated by our 25 closures in the first 9 months and up to 20 additional domestic store closures expected during the fourth quarter of this year. We expect the majority of these closures will occur at the end of the quarter. And with that, I'll turn the call back to Ravi.

Ravichandra K. Saligram

Thank you, Bruce. As I conclude today's call, I'd like to begin by saying our thoughts remain with everyone impacted by Hurricane Sandy. The safety of our associates, their families and our customers is our first priority. I'm very proud of how quickly and effectively associates, along with our suppliers, have pulled together to address the situation and to do what we can to enable all of us to return to a more normal state of affairs. Although it's too early to understand the full impact of the storm on our financial results, we do anticipate a modest sales impact. Our strategic plan that we showed investors last November highlighted 2 key pillars: first, an operational turnaround of our core business; and second, evolving our business model through innovation and disruptive moods.

In our August earnings call, we made more explicit a third pillar of our plan that relates to balance sheet management. I feel our team is making good progress on the operational turnaround of our core business. Year-to-date 2012 adjusted operating income is up 26%, adjusted operating margin is up 40 basis points, adjusted EPS is up 38%, and cash from operations of $158 million has doubled versus the prior year. And despite no tailwind from the economy, year-to-date, our U.S. Contract business, which includes our digital initiatives, has grown 4% versus the prior year, while total company sales on a year-to-date comparable basis are down a modest 20 basis points. We also made good progress on the balance sheet, reinstating the dividend, offering the pension lump-sum and extinguishing the non-recourse Lehman-backed timber notes liability. We will continue to work on other balance sheet items through the end of the calendar year.

This brings me to our final pillar, innovation in disruptive moods. Long-term, we need to evolve our business model. Find new categories to drive growth and importantly, to differentiate our brand. In order to provide focus, championship and momentum behind these efforts, I'm pleased to announce Kim Feil as our new Chief Marketing and Strategy Officer, who will report directly to me. In this newly created position, Kim will drive improved efficiency of our marketing spend, create better customer segmentation to develop an enduring and differentiated brand value proposition and leverage strategic insights to develop out-of-the-box ideas and drive enterprise-wide innovation. Kim was most recently CMO at Walgreens and has a rich consumer package goods background, including stints at PepsiCo, Cadbury Schweppes and Sara Lee.

And with that, let's take some questions. Bruce and I are joined by Michael Lewis, President of Retail; John King, President of Contract, Jim Barr, our Chief Digital Officer; and Ron Lalla, our Chief Merchandising Officer.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Michael Lasser with UBS.

Michael Lasser - UBS Investment Bank, Research Division

Bruce, if you just look at the U.S. contract business, what sort of leverage, operating margin leverage was there on a 3.9% sales increase during the quarter?

Bruce H. Besanko

Well, what we said just a few minutes ago on Ravi's prepared remarks and my prepared remarks was that as you know, the sales were up about $881 million. The U.S. business increased about 3.9% from the prior year second quarter. We had expansion, slight expansion in margin, although there was good, reasonably good expansion in customer margins. And we had somewhat decent SG&A performance, and so the net effect of that was 40 basis points of leverage.

Michael Lasser - UBS Investment Bank, Research Division

But presumably within that, there was some deleverage from the international business?

Bruce H. Besanko

There was a little bit of deleverage from the international. Those guys were down 8% in U.S. dollars and 7% on a local currency basis, and we've got a new sales leader in Canada, as Ravi mentioned, that's helping to drive sales performance there and we've been suffering from lower government purchases in both New Zealand and Australia.

Michael Lasser - UBS Investment Bank, Research Division

The second question is on the rent expense outlook for next year, given all the changes, I think you'd made some comments about how much that's going to come down in 2013 earlier in the year. Can you provide some update on what your expectation is now?

Bruce H. Besanko

Well, my preference is to provide that guidance for next year on operating expense on the next quarter's conference call. But suffice to say, that we've been, at least on the contract side, we've been lapping the closure of 3 CFCs, which should go away in the fourth quarter of next year and the fourth quarter this year and then we'll already lap as we turn into next year. So we won't be getting that benefit again. We're going to continue to make good progress with our developers on the retail side as we have in the past so I would expect that as we move into next year, we'll continue to be negotiating with our developers.

Michael Lasser - UBS Investment Bank, Research Division

This final question was or is on the softness that you talked about beginning in September and then it sounds like that's progressed into the current month. Can you provide some more detail on where you're seeing it? Is it exclusively in retail or is it across the entire business in the U.S?

Bruce H. Besanko

Well, so September sales were worse than expected. It was largely driven by weaker technology product sales, which continued through October. That was more a function in the Retail segment than it was in the Contract segment. We mentioned that October, that same phenomenon occurred in October. What I don't want to do is then go forward and extrapolate in regards to anything further beyond that and I would reference you back to the outlook that we gave in terms of the fourth quarter guidance for sales.

Michael Lasser - UBS Investment Bank, Research Division

Just to clarify, did the contract business also soften a bit in the U.S?

John C. Kenning

Yes, contract business in October, we did have some weakness in the business overall. We look at the rest of the quarter as being in line with guidance that we provided so far. So we feel comfortable with our projections.

Operator

Your next question comes from the line of Oliver Wintermantel with ISI Group.

Oliver Wintermantel - ISI Group Inc., Research Division

Can you maybe breakdown the U.S. contract that's...

Ravichandra K. Saligram

Oliver, we can't hear you.

Oliver Wintermantel - ISI Group Inc., Research Division

Can you maybe breakdown the 3.9% improvement in the U.S. contract business and what drove that? Was there like one-offs from last year where you had these weaknesses in the East Coast? Or what was the driver of that 3.9% increase?

Ravichandra K. Saligram

Let me kick it off and then John can add more color. First, I think there are really 2 components there. One is our digital initiatives, which continue to grow double digits, and they were profitable. So that clearly is one key part. On our U.S. contract business, I think it is just a continuation of a trend where all the fundamentals are doing better, which is our net new business. So wins minus losses are continuously improving, so I think that's good. Our retention are at record rates and we're making progress on the whole margin side. And as we are trying to get some of these adjacencies going, we had good adjacency growth in Jan-San, the facilities side and furniture continues to, on a year-to-date basis, we're having good progress. So I think the contract business, U.S. contract business, if you look at each of the fundamentals and the drivers of that business, they're doing well. And then the teams are very motivated and so I think that's really the key there.

John C. Kenning

So I think we planned a strategy and put a strategy together over the last number of months. We're continuing to execute that strategy in the marketplace. As Ravi mentioned, our net wins have continued to be a very positive trend for us overall, and our adjacencies in facilities products, furniture have also continued very strong growth. The last key what I would say, retention. We've had a very loyal and strong customer base that we continue to work with. We're continuing to bring value across our workplace to those customers, and we feel very comfortable with our retention rates and our customer base and the value proposition we're bringing towards them. So Ravi answered most of the questions, but those are my additional comments.

Oliver Wintermantel - ISI Group Inc., Research Division

Okay. And then just on the gross margin line in retail, up 100 basis points. Can you maybe just aggregate that into how much came from occupancy and how much came from the better mix shift away from technology?

John C. Kenning

Oliver, there were 3 principal drivers of the gross margin increase in retail: The first was the favorable sales mix shift from the lower margin technology category, the second was the occupancy and then the third was delivery expenses. So those 3 things particularly drove the gross margin increase.

Oliver Wintermantel - ISI Group Inc., Research Division

And can you break that down in basis points? Or are you not going to give that much detail?

John C. Kenning

Yes, I'm not going to give that much detail.

Operator

Your next question comes from the line of Christopher Horvers from JPMorgan.

Christopher Horvers - JP Morgan Chase & Co, Research Division

The store downsizing and relocation opportunity is accelerating for you guys. Can you talk about the new prototype? How large are you thinking there? How many prototypes will you have in the network kind of a large size versus a small size? And then from what you've seen, what has been the sales retention and four-wall profitability? Or how do you think about the sales retention four-wall profitability in a smaller box?

Ravichandra K. Saligram

Michael, do you want to?

Michael J. Lewis

It's Michael Lewis here. Let me just preface my comments by saying, we've got an overall strategy around improving our return on invested capital and retail, optimizing the retail network, rightsizing is extremely important to us, our downsizing growth to the actual downsizing of existing units and relocations, our efforts are very much towards heading towards a 15,000-square foot box or smaller. Specifically on the smaller-sized format, that is in the neighborhood of 5,000 square feet. We continue the development of this concept. We've got a team that's on it and it's engaged in terms of aggressively engaging the development plan. We've done a lot of customer research, very extensive, and have engaged very talented external resources here. We still plan to open our units in the first part of next year, as Ravi mentioned, and then we'll take this learning and then roll it into the relocations that we plan for next year and into our HG storage, where we've got the technology expansion.

Christopher Horvers - JP Morgan Chase & Co, Research Division

And then related to that, just curious on the distribution side, how does the model change on a 5,000-square foot box versus the larger box. Is there a loading bay in the back? Are you taking products to the front door? Is it more direct from the vendor? Or is it still distribution based -- distribution center-based?

Michael J. Lewis

The experience we have at this point in time is principally smaller back rooms, still with direct delivery from our DCs with very little direct delivery from vendors. We're still working that through. There could be some changes as we get through the business operating model, but that's what we expect.

Christopher Horvers - JP Morgan Chase & Co, Research Division

And then one more follow-up on the current sales trends. Windows 8 came out a couple of weeks ago, and I know you talked about continued kind of weakness in October. Clearly, the consumer and the elections are -- could be contributing to that, but have you seen a noteworthy increase in technology sales now that Windows 8 is out and surely some pent-up demand is releasing?

Ravichandra K. Saligram

Ron, why don't you address that?

Ronald Lalla

This is Ron Lalla. So Windows 8, again, it's released, right. It was released October 26. Our approach to Windows 8 was to really educate our target customer on what exactly are the benefits for Windows 8. I would say this to you that we have seen that our expectations for Windows 8 have been met over the last 9 days. It's still early to say if this will continue on, so we should have more information as the quarter progresses. It's been so far, our overall technology sector, as mentioned by Bruce, can still see softness in the technology sector.

Ravichandra K. Saligram

Chris, I'll just add something, which is, so what we've been doing is being judicious about it. On one hand, we need a foundation in technology because that's an important part of being an office superstore, and we still feel we are not getting our fair share even within this channel. Having said that, we want to be very judicious about how we balance about giving the customer the right assortment and choice, while managing for inventory risk and profitability. So that's why we took a strong decision to cut our assortment in PCs by half and we're moving up some of the tablets. But I think it is, when we get laser-focused on the small business customer rather than the individual one, we don't want to go after the bottom fishers.

Christopher Horvers - JP Morgan Chase & Co, Research Division

And as you think about that, as you think about the new hardware surrounding Windows 8 and just the overall tablet product and presumably particularly in Windows 8, is there less accessory attachment opportunities and really, the attachment becomes the services side or how do you think about it?

Ravichandra K. Saligram

Ron?

Ronald Lalla

We still see accessories being a big part of the Windows 8, and we also still see the services being a big piece of it. I think when you look at the hardware, it's really different form factors, first, in terms of if you look at it from a spectrum of e-readers, tablets, laptop, there's still attachment that goes with each one of those form factors and the services carried with those form factors. So the business model in our opinion still would.

Ravichandra K. Saligram

A final point there, Chris, is the service side, in terms of new services, that's where we are making a very aggressive push. As I said in my prepared remarks, they're going to be launching several new services in the new year, and at this point, I don't want to go into specifics on what they are. But suffice to say, that's where there's a lot of proactive work going on in our place.

Operator

Your next question comes from the line of Greg Melich with ISI Group.

Gregory S. Melich - ISI Group Inc., Research Division

I have 2 follow-up questions. One, is you mentioned that Mexico will have an extra month in the fourth quarter? Could you just quantify that for us, Bruce?

Bruce H. Besanko

What I would do is take the 2011 sales for Mexico, divide by 12, and that's a fairly good approximation.

Gregory S. Melich - ISI Group Inc., Research Division

And then second, you mentioned a 2.9% drop in spending with existing contract customers. Is that ticket or items or what are we seeing them spend less on?

Ravichandra K. Saligram

John?

John C. Kenning

So, Greg, what we've seen is with the secular decline in our core business, we've seen that reduction. Our adjacencies, as we mentioned earlier, are growing particularly in the facilities products, they're double-digit year-to-date. They're just not big enough to offset that decline overall, so we're working that existing customer base. The great thing in the existing customer base is our retention rate. Is that an all-time high, so we've been able to retain our customer. Now with some of the new adjacencies and offerings that we're bringing to the marketplace. We believe as we go forward, we'll be continuing to reduce the existing decline that we have. We've seen that over the last few years. We've done a great job of reducing that decline. We continue to focus there.

Ravichandra K. Saligram

So let me just add one thing there, which is last year, 2011, when we began this journey, our existing declines were sort of in the 6% range. So we've cut that in half, and I think that's been systematic. So I think the issue with the contract businesses, the premier large contracts when these get renegotiated, the pricing invariably comes down. The question is how much. But when it comes down, even if you're selling the same volume, because the pricing came down slightly, your revenues go down. So I think that's a matter of fact here. So the important thing is what John said is we're now trying to get additional sales, which are also at the same margins or better margins, which are the adjacencies. But you've got to look at the model in totality. We don't see anything in the existing side that gives us any cause for alarm or shift in worries because we just see that natural trending is taking place. And when you look at the off-contract, on-contract trends, I think they are still holding. And so all in all, I'd say, I feel very good about the operational health of the contract business.

Operator

Your next question comes from the line of Brad Thomas with KeyBanc Capital Markets.

Bonanza Chalaban - KeyBanc Capital Markets Inc., Research Division

This is actually Bonanza Chalaban in place of Brad. Could you give an update on Croxley and just where you are in the selling process on that?

Bruce H. Besanko

So as we've said in the past, Croxley is a business in New Zealand. It's very well led. Its book value is somewhere in the order of $45 million to $50 million, depending on how much cash they may hold at any given time. It's a reasonably sizable business for us in New Zealand. As we said, it's well led. We have hired a transaction partner to assist with an evaluation in regards to the consideration of the business. We're in the process right now of assessing whether there's market interest that achieves our price expectations, and I would expect that by the next conference call, we'll have more to say about it.

Ravichandra K. Saligram

And the key for us is, look, there's no question in our mind that this is non-core, but we do need to when divest it, get the value that we want for shareholders. And that's really the issue and we're still marketing the property to see where we go.

Bonanza Chalaban - KeyBanc Capital Markets Inc., Research Division

Okay. And then I know there was a question asked already, but maybe just said another way, gross margins, net retail, you saw a pretty big improvement this quarter. I mean do you think that can continue to expand in the fourth quarter if you had the tech category rebound?

Ravichandra K. Saligram

Bruce?

Bruce H. Besanko

Sure, as I said, as I mentioned before, there are 3 big drivers to it: The sales mix shift from the technology category, which has lower margins, occupancy and delivery. We've made good progress over the course of the year on supply chain, and so I'm looking forward to continued benefits in our supply chain area. We're going to continue to work our developers to seek value where we can in terms of our real estate for trying to leverage our occupancy. And then as I think about the technology category, as Ron and Michael have both alluded to, we're reducing the level of technology assortment in the stores at least for the time being. And so to the extent that it has a benefit, we'll see it pick up in gross margin.

Michael J. Lewis

And Bruce, this is Michael, if I could add to that. The continued growth for our tech accessories and tech services business is very helpful for gross margin. And as Ron alluded to earlier, regardless of whether that's a laptop or whether that's a tablet, we're seeing good performance there. And secondly, we continue to grow our private label and our global sourcing efforts in our business and that's good on gross margin.

Operator

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

Unknown Analyst

...in behalf of Matt Fassler. We were wondering if you could please comment on the competitive environment in the U.S. contract business.

John C. Kenning

So this is John Kenning. So the competitive environment across U.S. contract has remained, as we continue to see it, a strong competitive marketplace. We feel that as we look at the marketplace, we're doing some things, first of all, in the retention area to retain our customer through our customer service capabilities, through our distribution capabilities, which we think is key. Second thing as we talked about in the net win area, I think some of the things that we're doing with the customer increasing as we've changed our name to Workplace, our offering, our service, our sales representation out in the marketplace. We see ourselves continuing to have net wins and we feel very comfortable and good about that. The marketplace is competitive but has not significantly changed over the last few months.

Unknown Analyst

One follow-up question. We were wondering if you could breakout the calender adjustment alone for the third quarter. I think you disclosed the adjustment for the extra week closure and currencies.

John C. Kenning

Well, the fiscal week that was extra in 2011 was actually in the fourth quarter and it was $86 million of sales, and call it, about $8 million of EBIT contribution in that extra 53rd week of 2011.

Operator

Your next question comes from the line of Alan Rifkin with Barclays.

Alan M. Rifkin - Barclays Capital, Research Division

Questions if I may, is the acceleration in the stores to be closed more so a function of a greater number of stores now deteriorating or is it more so a function of you maybe raising the thresholds on an ROIC or IRR basis?

Ravichandra K. Saligram

Let me start and then Michael can add to it. I think it's the latter. And as I mentioned at the investor conference that I'd hold the team to a significantly higher standard, that the modeling that our finance group would do would be extremely rigorous and tough and that we would not look at the world through rose-colored glasses, and that we needed to address and make bold decisions. And so I think we are doing just that and saying we need to, if they're unprofitable, we will address them. So, Michael, do you want to add anything to that?

Michael J. Lewis

Yes, Ravi, it's Michael here. Let me just add to that. Our closure decisions are always based on economic analysis, the cash flows in stores, current and future, and in the context of the market trade area and the location we're in. I say we're getting aggressive around both of those, particularly in the latter, but I just want to recall for all of you that in conjunction with our rightsizing activities, we've also got major efforts against driving our sales per square foot through topline growth, and that's around building our price image as we've indicated earlier, driving our tech business to get our fair share and building our services business, as Ravi mentioned earlier. I will give more details around further closures, I guess, when we meet and talk in early 2013, as Bruce mentioned. But again, our objective is optimize this retail store network, and decisions will be based on a store-by-store basis, including what the market potential is and site location potential is and what the opportunity is for relocation to a smaller unit.

Alan M. Rifkin - Barclays Capital, Research Division

Okay. And one follow-up, if I may. Ravi, you've been quite clear in explaining the nonrecourse nature of the Lehman liability for years. Now that it's officially all through a balance sheet, do you suspect that any vendors, if at all, may look at the fact that it's now been extinguished and possibly improve terms with any of your vendor base?

Ravichandra K. Saligram

So I think what it does whether its investors or vendors, it provides greater clarity to our balance sheet, the optics improved, and so it's tough to really quantify that to say with vendors, does that actually help the terms. We always try to push for the best terms anyway, so but I do hope with investors that when they do their screens, some of the new investors, they'll look at us more favorably as they screen for this.

Bruce H. Besanko

And I'm going just to add to that, Alan. With respect to our vendor population, we go through with them in regards to some of the complications, in regards to the balance sheet. If necessary, we go through some of the details so that they can fully understand the nonrecourse nature of the timber notes. And so we've never had an issue with vendors, frankly.

Operator

Your next question comes from the line of Anthony Chukumba with BB&T Capital Markets.

Anthony C. Chukumba - BB&T Capital Markets, Research Division

Could you just touch base a little bit in terms of your small and medium-sized business efforts? I know you mentioned that you rolled it out to 10 sales or 10 markets at this point. I was just wondering if you could give us any color in terms of what -- in terms of how the actual sales are trending in those markets, I mean what kind of traction you're getting with that effort.

Ravichandra K. Saligram

John, why don't you address that?

John C. Kenning

So as we mentioned, Anthony, in our last call, that we had rolled out to 8 over the last period of time. We've now rolled into 10 different marketplaces. We're seeing the traction that we had planned. The one area where we are seeing better traction is on new acquisition of customers, so we're very pleased with that in each of the marketplace. And as we continue to look at that market, we will make the right diligence on adding additional marketplace over time. But so far, we're very pleased with our SMB plan, our SMB growth in total and see a continuation of that marketplace. The next thing we will be doing with the SMB team is continuing to work with them to bring new offerings from our adjacencies to those level of customers. But so far, it's been very good.

Ravichandra K. Saligram

Anthony, it's just to put it a bit in perspective. You remember when we launched this and talked about it in November when we did the strategic plan, our initial plan was to going to 4 markets, so we've gone 4, 8 and 10 as John mentioned. But at the end of the day, this is -- it's still an embryonic process because we are hiring the sales people, ceding them into the markets, and this is all about depth rather than breadth and really gaining critical mass in those markets and where our sales force starts getting the relationships. And then so it's a push-pull, we go call on our customers, get them to the door and then through our inside sales and telesales, pull them. So this model will take time to scale. So on the other hand, we have met, we look at account openings and so on and on those basis, we feel we're making good progress. But it will take time to scale this, and I just want the expectations to be moderated based on that.

Anthony C. Chukumba - BB&T Capital Markets, Research Division

Okay. And then just one quick follow-up. I mean, what's your expectation for rolling out into new markets in Q4 this year and also just sort of just early thoughts on rolling it out to additional markets in fiscal year '13?

Ravichandra K. Saligram

Let me do a quick run on that. We've just got into the additional markets. As I said, I think our next phase is to be very -- is to really build depth into those marketplaces. So this is not like large and enterprise, where we're getting the national footprint. It's urgency, it is more once you get into a market, building by building, getting their accounts and penetration in these urban markets and I think that's where our focus is.

Operator

Your next question comes from the line of Scott Tilghman with Caris & Company.

R. Scott Tilghman - Caris & Company, Inc., Research Division

Wanted to touch on the balance sheet and asset allocation quickly. You talked about Croxley. Obviously, Boise, you're sitting on $270 million investment between the dividend and the original investment. Public comps you're saying that company is worth probably 3x your initial investment. Do you have any sense as to when Madison begins to move forward given the rapid profit improvement they've seen at Boise?

Bruce H. Besanko

Let me take a step back and first broadly address the balance sheet review that we're undertaking. I'll address the Boise question specifically. So first of all, I want everyone to know that we have a keen sense of urgency in addressing the complexity of the balance sheet. Fortunately, we've had some good news in regards to our Lehman extinguishment. We're also working on the pension lump sum payment. But I do want everyone to know that we have a keen sense of urgency. And our decisions, as Ravi had said, will be based on maximizing shareholder value. And just so everyone knows, there is a level of complex interdependency here, and so it does take time and careful consideration. Part of the balance sheet review includes capital allocation. And as we've said before, no options in regards to capital allocation are off the table. Now you've asked specifically about Boise. As you said, Boise, we have $175 million of minority equity stake in Boise Cascade. We also have a dividend receivable that's about $43 million. We continue to have dialogue with Boise in regards to our investment. In fact, we sit on their Board, with Madison Dearborn, and continue to have an active dialogue and so the nature of the investment is complex. We push as hard as we can, given our rights in regards to the minority ownership. But all of our decisions are going to be governed by maximizing shareholder value.

Ravichandra K. Saligram

Bruce, let me just add a couple of things to that. Number one, there's no question that this year, Boise has been performing well. We are also encouraged that the housing market is doing well. So I think those are all good points. We also recognize that the Boise investment first is a non-core asset, and we will continue over the dialogue and look for ways at some point how we can monetize this investment. Having said that, I think the key is, we want to make sure our that investment gets the right value for our shareholders.

R. Scott Tilghman - Caris & Company, Inc., Research Division

So let me just follow-up on that. You said all aspects of capital allocation are open, but I want to ask one thing specifically, is the Board open to the concept of share repurchases?

Ravichandra K. Saligram

So I'll be very emphatic about it, which is, the Board and I are totally aligned. No option right now is off the table, and that includes various ways of looking at providing values. So let's just -- we want to continue our analysis, these complexities, and we need to keep working at it.

Operator

At this time, there are no further question.

Ravichandra K. Saligram

Thank you very much, and we'll see you next year.

Operator

This concludes today's conference call. You may now disconnect.

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