OfficeMax Incorporated Management Discusses Q1 2013 Results - Earnings Call Transcript

| About: OfficeMax Incorporated (OMX)

OfficeMax Incorporated (NYSE:OMX)

Q1 2013 Earnings Call

May 07, 2013 10:00 am ET


Michael Steele

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

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

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

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


Oliver Wintermantel - ISI Group Inc., Research Division

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

Michael Lasser - UBS Investment Bank, Research Division

Gary Balter - Crédit Suisse AG, Research Division


Good morning. My name is Mari, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the OfficeMax First Quarter 2013 Earnings Conference Call. [Operator Instructions] It is now my pleasure to introduce you to Mike Steele, Vice President 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 on our website for one 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 meanings 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.

In addition, we may make statements on this call concerning our pending merger with Office Depot. These statements are not an offer to sell any securities or the solicitation of any vote by or on behalf of OfficeMax or Office Depot or their respective directors and executive officers. Investors should read the joint proxy statement and prospectus included in the registration statement on Form S-4 filed by Office Depot with the SEC. These documents contain important information concerning the merger and can be obtained for free at the SEC's website or by contacting Investor Relations.

Now I'll turn the call over to our CEO, Ravi Saligram.

Ravichandra K. Saligram

Thank you, Mike. Good morning, everyone, and thank you for joining us. It's nice to have some time with you again this morning. The last earnings call we hosted was in November on election day. Much has happened since that time. And while we posted a year end 2012 script in February, I'd like to take a moment to recap some of the highlights from the year.

In 2012, our associates delivered significant progress on our strategic plan, which resulted in positive changes to the business and meaningful margin improvement during the year. Full year 2012 adjusted operating income was up 18%. Adjusted operating margin was up 30 basis points. Adjusted EPS was up 28% and cash from operations was $185 million, which is more than triple the prior year.

Additionally, U.S. Contract grew 2.3% after adjusting for the 53rd week. We booked double-digit growth in our e-commerce initiatives, gained traction in our key growth adjacencies and aggressively optimized our U.S. Retail store network. For more information about our progress, please refer to the introductory section of our annual report posted within the Investor Relations portion of our website.

As you know, in February, we announced a proposed merger of equals with Office Depot. Without question, this event is the highlight of our first quarter. This historic merger of 2 Fortune 500 companies offers the potential to create a stronger, more efficient global provider, better able to meet the growing challenges of a rapidly changing industry.

The proposed merger, which was unanimously approved by the boards of directors of both companies, creates the platform needed to more rapidly scale the great ideas that exist within each company, in turn, accelerating innovation, improving the customer experience and building real competitive advantage.

The compelling cost synergy opportunities in the range of $400 million to $600 million by the third year following transaction close clearly provide financial performance, enhanced financial performance, for the combined company.

While a significant portion of the cost synergies are expected to drop to the bottom line of the combined company, there is also the opportunity for some of the synergies to be reinvested in initiatives that benefit the customer. All of this creates long-term opportunity for our shareholders, customers, vendors, associates and other stakeholders.

Within the quarter, we also addressed 2 important matters that fully closed out our balance sheet assessment: first, we terminated the sale process for our Croxley business in New Zealand since we did not receive offers that reflected the true value of the business; and second, it brings me great pleasure to announce the return of approximately $130 million to our OfficeMax shareholders in the form of a special dividend of $1.50 per share of common stock.

This dividend represents a return of the monetized portion of the Boise investment. As a reminder, we continue to retain 20% ownership in Boise Cascade Holdings, which represents an indirect stake of approximately 6 million shares of Boise Cascade company, which recently filed an IPO.

Turning to first quarter results. The first 3 months of the year unfolded against a backdrop of continued economic uncertainty. Our sales continued to be negatively impacted by customers reducing spend across all of our business segments, and our adjusted sales were 4.3% lower than prior year. The sales weakness that we experienced in late 2012 deepened more than expected in the first quarter as our customers remained cautious in their spending. We believe uncertainty related to cuts in public sector spending associated with the sequestration, the barrel tax hike and changes in health care laws, have meaningfully impacted customer behavior.

Sales in the quarter were also negatively impacted by nearly 1 point due to a shift in the timing of the New Year and Easter holidays versus the prior year.

Gross margin improved slightly for the quarter but was not enough to offset the decline in sales volumes. We continue to drive cost reductions and prudent use of capital as we navigate this challenging environment.

A key challenge going forward remains restoring top line growth. Consequently, we continue to develop, test and implement innovations aimed at driving growth and enabling us to build deeper connections with our customers.

In the first quarter, we delivered on a number of key initiatives. We were pleased to introduce our new OfficeMax Business Solutions Center. The new store format is a first of its kind for OfficeMax in the U.S., offering 5,000 square feet of specially tailored business services solutions and products delivered by expert associates to help local entrepreneurs grow their businesses. We believe this format will be most effective in trade areas that have a high concentration of small businesses.

We continue to drive our multichannel initiatives and improve the capabilities of our digital properties. We continued the rollout of our in-store service offerings, specifically designed to support the needs of small businesses. And our merchants increased their efforts to develop new categories to attract customers to our stores.

So here's what we plan to cover today. I will share highlights from the first quarter and update you on the forward progress of our key initiatives, then Bruce will walk through the financial details of the quarter as well as our outlook. I'll close with an update on merger activities and then we'll move on to Q&A.

Let's turn to our Contract segment performance. Sales in the U.S. Contract business, which includes our digital initiatives, declined 3.5% during the first quarter. However, Contract segment gross profit margin remains strong, increasing 30 basis points from a year ago. We believe the primary reason for the decline in sales is significantly reduced purchases from our existing large and enterprise customers.

In particular, we saw weak demand within the federal government and education sectors. While we maintain a high quarterly customer retention rate of greater than 92%, our new business implementations did not occur as fast as we expected, and as such were unable to offset losses. Of particular note, we continue to make good progress with new account acquisition in the small and medium business growth adjacency as we expanded this initiative into grow [ph] markets.

We also maintained high double-digit growth rates in facilities products. Overall, declining sales in the Contract segment translated to significantly lower segment income in the first quarter.

Further impacting our Contract business was an international sales decline of 5.4% in local currencies versus the prior year, which was negatively impacted by approximately 3 percentage points due to fewer business days this year. Sales declined in Canada, and to a lesser extent, in New Zealand, were slightly offset by modest growth in Australia.

Turning to our digital initiatives. We've been making and will continue to make significant investments in our e-commerce platform. These investments have proven to be beneficial to top line growth and are key levers to delivering the multichannel experience today's customers want and expect. Some specific digital highlights for this quarter include: We increased traffic to our websites and drove significant improvement in conversion rates. This resulted in double-digit sales growth for We implemented 5 website releases related to content and navigation enhancements during the quarter, including a search engine upgrade for all -- for our office -- for our business-to-business e-commerce platform; also, we enhanced the checkout experience and enriched the overall content of our websites.

Back in November, we launched an omni-channel initiative, Online Store Pickup, where customers can conveniently buy products online and pick them up in our stores within 2 hours. During the first quarter, we saw increased utilization of this capability and our order fill rate has steadily improved since launch.

Moving on to our Retail business. First quarter U.S. same-store sales comps declined 5.7%. The business experienced softness across all product categories, with the steepest declines overall in PCs, reflecting the well-documented industry challenges. At the same time, we continue to narrow our focus in the technology category to products geared to the small business customer and, in general, are taking a more cautious approach and have been significantly shrinking our PC assortments.

Our modified approach, through technology offerings, yielded a more balanced inventory mix of PCs, tablets and mobile accessories in the first quarter, providing an appropriate level of product selection for the customer while managing inventory risk. Consequently, we required significantly less PC clearance through the end of Q1 as compared to the prior year.

Controlled by the adequate use [ph] of promotional activity kept customer margins higher in the Retail business. We continued to build momentum with our in-store services in the first quarter. This was partially due to the launch of 4 new services in Q1, including the national rollout of GoDaddy Web services and MiMedia cloud services. We expect to continue to launch more services each remaining quarter in 2013.

We're also significantly increasing our training for our store associates, enabling them to provide the consultative services and solutions our small business customers demand and to increase attachment sales and develop relationships that drive repeat business. Our differentiated service offerings cater to the value-conscious small business owner and are an important enabler of the transformation of our Retail segment.

We achieved a strong improvement in our customer satisfaction rate in our Retail portfolio and a higher year-over-year conversion rate during the first quarter. As we continue to challenge ourselves to streamline our retail cost structure, our team successfully improved scheduling efficiency without impacting the customer experience.

Last year, I provided you with specific Retail initiatives aimed at improving our day-to-day Retail execution amidst industry-wide structural challenges. Let me provide you with an update. First, we continue to rationalize our domestic store network and focus on strong cost controls in our stores. We closed 46 stores in 2012 and another 5 stores in the first quarter. We've removed approximately 6 million gross square feet of store space in the U.S. since the beginning of 2005. We expect to close a total of 15 to 20 stores this year, along with selective relocations and downsizes. These steps to optimize square footage are held by a flexible portfolio of lease commitments. Looking out beyond this year, greater than 85% of our store leases are scheduled to expire during the 5-year period of 2014 through 2018.

In 2013, we've also introduced a smaller format store in Milwaukee and in Portland as a pilot program. The new format stores are geared specifically to serve the needs of the small business customer. Early feedback on these stores indicate that the new design of the stores strengthened associate consultative capabilities, and the small business-oriented product and service offerings are being well received by customers.

An kiosk in the store provides customers with endless access to thousands of additional products. We continue to evaluate additional sites in urban locations with a high density of small businesses where we can provide services and solutions to small business needs.

Second, we continue to drive innovation in our existing store portfolio. We introduced the first of 5 remodeled laboratory stores intended to provide an environment for fast continuous experimentation to drive traffic, conversion and customer satisfaction. The laboratory stores will provide an exciting look at how we can bring multiple innovations together to transform the customer experience through a solutions-driven approach.

In addition to an overall remodel, the laboratory store now offers a broader assortment of tablets and mobile accessories in our tech area; a new furniture layout that enables customers to try a variety of solutions tailored to their work environment; better integration of service offerings within our print and tech centers and an expanded solution center for cleaning break room and janitorial supplies. Successful aspects of the pilot programs are expected to be rolled out into 100 accelerator stores in 8 markets.

Moving to our Mexico Retail operations. Same-store sales decreased 2.1% on a local currency basis, driven by weakness in the technology category. There were 90 OfficeMax stores in Mexico as of the end of the first quarter, and it continues to be a profitable growth adjacency to our business.

At this point, I'll turn it over to Bruce for a 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 first quarter of 2013 decreased 5.7% to $1.8 billion compared to the prior year period. Adjusted for currency translation, store closures and fewer business days this quarter, the consolidated adjusted sales decline was 4.3% versus the prior year. The holiday schedule negatively impacted the decline by nearly 1 percentage point in Q1 2013.

First quarter Contract segment sales were $921.3 million, a decrease of 4.1% compared to the first quarter of 2012. The difference in the number of business days for the quarter accounted for approximately 1 percentage point of the decline.

In our U.S. Contract business, which is approximately 2/3 of our Contract segment, sales decreased 3.5% from the prior year's first quarter. Sales to existing customers declined 4.6% and net new sales were negative.

In Q1, sales in our international Contract business decreased 5.4% in U.S. dollars, or a decrease of 5.2% on a local currency basis, compared to the first quarter of 2012. Approximately 3 points of this decline was due to the difference in the number of business days compared to the prior year period.

First quarter Retail segment sales decreased 7.3% to $845.4 million compared to the first quarter of 2012, reflecting fewer stores and a 5.4% decrease in same-store sales on a local currency basis. U.S.-only Retail same-store sales decreased 5.7%, driven by a mid-single-digit decline in transaction counts and comp sales declines in all 3 product lines. We experienced the steepest declines in technology, which comped down high-single digits and more modest declines in supplies and furniture. Average ticket was approximately flat despite significantly lower PC sales.

First quarter Mexico same-store sales decreased 2.1% on a local currency basis. We opened one store and closed one store in Mexico.

OfficeMax gross margin was 26.0% for the first quarter, an increase of 20 basis points compared with the prior year period. Contract segment gross margin increased 30 basis points for the first quarter, primarily reflecting higher customer margins. Retail segment gross margin increased 30 basis points, in total, for the first quarter. The rate increase was driven by a sales mix shift away from the relatively lower margin technology category, especially PCs, which was partially offset by deleveraging of occupancy cost due to lower sales and the expiration of the favorable purchase accounting for leases from the 2003 acquisition of the U.S. Retail business, which expired at the end of 2012.

Adjusted total operating expense, which includes general and administrative expense, increased to 24.7% of sales in the first quarter of 2013 compared to 23.6% in the prior year quarter, which was approximately -- but was approximately $5 million lower, on an absolute dollar basis. Contract segment operating, selling and G&A expense was 21.0% of sales for the quarter, up from 19.6% in the first quarter of 2012. The increase was primarily due to the deleveraging of expenses due to lower sales and investments in growth and profitability initiatives.

Retail segment operating, selling and G&A expense was 27.6% of sales in Q1 2013 compared to 26.8% in the first quarter of 2012. This increase was due primarily to the deleveraging of expenses due to lower sales.

Adjusted operating income margin for the first quarter of 2013 decreased to 1.3% from 2.2% in the prior year period, due to 110 basis point decline in the Contract segment and a 60 basis point decline in the Retail segment.

As we mentioned in this morning's press release, Corporate and Others segment operating expense was approximately $9 million in each period.

For the first quarter of 2013, we recorded adjusted net income of $10.1 million or $0.11 per diluted share compared to $19 million or $0.22 per diluted share in Q1 of last year. I want to remind you that these numbers exclude all Boise-related income, as well as merger-related expenses, however, the adjusted profitability comparisons include the impact of the expiration of the favorable purchase accounting for leases.

Please note that adjusted sales growth, adjusted operating income, adjusted net income and adjusted earnings per share are non-GAAP financial measures, which we reconcile to GAAP financials in our press release and Form 10-K.

Now turning to the balance sheet. At the end of the first quarter, we had cash and cash equivalents of $579 million in total debt, excluding the non-recourse timber securitization notes, of $237 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 we've 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 credit rating agencies, exclude this debt from the calculation of various financial metrics and ratios used to assess the valuation of the company.

Now turning to working capital. Inventories and accounts payable at the end of Q1 were $34 million and $21 million lower, respectively, as compared to the prior year period, primarily reflecting reduced sales volumes across the business, especially in PCs. Accounts receivable at the end of the first quarter were $9 million higher than the prior year period, primarily due to a higher vendor receivables balance.

Looking at cash flow, we generated $33 million of cash from operations in the first quarter of 2013 compared to $87 million in the prior year period. The decrease primarily reflects unfavorable working capital changes and lower adjusted earnings. As mentioned in our Q4 earnings script, accounts payable were unusually high at the end of 2012, primarily due to the favorable timing of certain items.

Related subsequent payments in Q1 resulted in an unfavorable use of working capital during the first quarter of 2013 as the accounts payable balance is now returning to a more normalized level. The timing of vendor receivables also contributed to the unfavorable working capital change, and there were higher incentive compensation payments made in the first quarter of 2013 than the prior year period.

Capital expenditures, which were funded by cash from operations totaled $28 million in the first quarter of 2013. This was primarily used for systems improvements related to our growth initiatives, software enhancements, including our ongoing SAP implementation, and infrastructure improvements.

Now turning to outlook. Our April sales trends have improved slightly from Q1. We remain focused on containing costs as we work to restore the top line while continuing to invest in our most critical core growth adjacencies.

So for the second quarter, we anticipate that total company sales will be lower than the second quarter of 2012, including the projected favorable impact of foreign currency translation. We also anticipate that for the second quarter of 2013, adjusted operating income margin will remain positive but significantly lower than the adjusted margin rate in the second quarter of 2012. Keep in mind that the prior year period included both the dividend income from Boise and the positive impact from the favorable purchase accounting for leases.

With respect to consolidated gross margin, we expect a flat gross margin rate for the second quarter compared to the 25.6% rate in the prior year period, despite the expiration of the approximately $3 million favorable purchase accounting for leases I just mentioned. We expect SG&A expense as a percentage of revenue to be higher than the second quarter of 2012, primarily due to lower sales volumes.

Now turning to the full year 2013. We anticipate that total company sales for the year will be lower than the prior year, including the projected favorable impact of foreign currency translation. Also keep in mind that we've been ticking a significant number of stores out of our U.S. Retail network, which impacts our overall reported sales growth rate. We expect sales decline to continue through the year but at a less negative rate than the first quarter of 2013.

Adjusted operating income margin for the full year 2013 is anticipated to be lower than the adjusted margin rate in 2012, but higher than the adjusted margin rate for the first quarter of 2013, with adjusted operating income margin in the second half of 2013 anticipated to be better than the second half of the prior year. Also keep in mind that 2012 included the positive impact of the $11 million from the expiration of the favorable purchase accounting for leases and approximately $8 million of Boise dividend income related to the 2003 merger.

With respect to consolidated gross margin, we expect a slightly higher rate for the full year as compared to the 25.8% rate for 2012, despite discontinuation of the previously mentioned purchase accounting for leases item. Until late in 2013, our gross margin should benefit from our COGS initiatives and a sales mix shift from fewer sales from the technology category on the Retail side of our business due to adjustments in our offering that we mentioned earlier. Also note that we currently expect year-over-year fuel-related costs to be neutral to slightly positive to gross margin this year based on the U.S. Department of Energy forecasts.

We expect full year adjusted SG&A expense to be approximately in line with to slightly lower than the prior year, but higher than last year as a percentage of revenue due to the deleveraging from lower sales volumes.

Our outlook also includes the following assumptions for the full year 2013: first, capital expenditures of approximately $80 million to $90 million, primarily related to investments in IT, e-commerce, infrastructure and maintenance, which is significantly lower than our prior guidance. 2013 is a year of continued investment in our transformation but given the market dynamics, we've modified this year's CapEx to more closely match last year's investment levels. Depreciation and amortization are approximately $75 million to $80 million; cash contributions to the frozen pension plans of approximately $3 million due to the pension funding stabilization legislation that took effect last summer; pension expense of approximately $3 million; interest expense of approximately $65 million to $69 million and interest income of approximately $42 million to $45 million; and adjusted effective tax rate of approximately 34%; cash flow from operations, excluding merger-related costs, to exceed capital expenditures; a net reduction in retail store count for the year, with 15 to 20 store closures in the U.S., selective relocation and downsizing of existing stores and selective openings of new smaller format concept stores. Additionally, we expect a total of 4 store openings and one store closure in Mexico.

And with that, I'll turn the call back to Ravi.

Ravichandra K. Saligram

Thank you, Bruce. While the first quarter results were below our expectations and economic challenges continue, we're making progress on our strategic plan, driving continued gross margin improvement and proactively reducing cost while building an innovation pipeline and increasing our emphasis on services.

On the merger front, in early April, we and Office Depot were very pleased to announce several significant milestones in the merger process. First, we passed some key regulatory milestones with the filing of the registration statement on Form S-4 with the U.S. Securities and Exchange Commission. Each company also received the anticipated second request from the FTC. Both companies are responding promptly and continue to work cooperatively with the FTC. We still anticipate the transaction to close by calendar year end, subject to shareholder approval from both companies and other customary regulatory approvals.

Neil Austrian, Chairman and CEO of Office Depot, and I identified the co-chairs for the integration planning process; Bruce Besanko, OfficeMax EVP, CFO; and Mike Newman, Office Depot EVP and CFO. Bruce and Mike are sharing the important task of building an integration team chartered with developing a plan to ensure a smooth and productive transition while capturing the anticipated cost synergies.

Neil and I are staying closely involved and providing overall stewardship and sponsorship of the process. We have a small group of associates engaged in merger integration work, while the vast majority of our team continues to focus on running our independent business.

And finally, the boards of both companies also appointed the CEO selection committee comprised of 3 board members, each, from our respective boards. The selection committee members are overseeing a comprehensive search process that considers Neil and myself, as well as external candidates. The objective remains to select the CEO for the combined company at or prior to transaction close.

As milestones occur, we remain diligent about communicating with our associates. We are frequently hosting town hall meetings, have launched an integration hub on our intranet and are generally increasing the intensity of our communications overall. We view our associates as the most critical assets of the business and are focused on keeping associates engaged and morale strong.

The OfficeMax board and I are committed to addressing important issues for shareholders that impact the merger and are steadfastly working towards making the merger successful. Many of you have heard that Office Depot has received an offer from its joint venture partner, Gigante, to sell its interest in the JV in Mexico, Central America and Columbia.

Under our merger agreement, any such transaction requires our consent. Since the execution of the merger agreement, we've done a great deal of analysis, both independently and with Office Depot, to gain a deeper understanding of the Office Depot joint venture with Gigante, its value and important strategic and non-financial considerations.

Consequently, we will continue to work constructively with Office Depot to pursue the best outcome for shareholders. We hope you understand that we cannot provide real-time updates on any developments in this matter.

Although we remain competitors with Office Depot until the merger closes, all of these achievements have required an immense amount of teamwork between the OfficeMax and Office Depot teams. Neil and I have every confidence our teams will continue to press forward with the highest sense of urgency and collaboration, while remaining independently focused on running our respective businesses well.

And with that, we're glad to take some questions. Bruce and I are joined by Michael Lewis, President of Retail; John Kenning, President of Contract; Jim Barr, Chief Digital Officer; Kim Feil, our newly joined Chief Marketing and Strategy Officer; and Ron Lalla, our Chief Merchandising Officer.

Question-and-Answer Session


[Operator Instructions] And your first question comes from the line of Oliver Wintermantel with ISI Group.

Oliver Wintermantel - ISI Group Inc., Research Division

You reported this quarter that traffic was down and you said you were less promotional and gross margins were up again in the quarter. Is there any strategy that you might be able to sacrifice gross margin for, for up traffic? Or how do you think about that?

Ravichandra K. Saligram

So let me kick it off and then, Michael, if you are on, want to talk about it? So I think we're trying to find an effective balance on that, Oliver, and then, I think, on the promotional activity, part of it was also related to the fact that we didn't have the clearances the way on tech that we had last year. So one of the things on our pricing strategy is just to make sure that on key value items for small businesses, that we are competitive. So I think it's very key we look at driving the traffic as a very important thing. So we think we have an effective balance on price versus margins. Ron or Michael, do you want to add anything?

Michael J. Lewis

Ravi, it's Michael here. I can add a couple of points. Additionally, if we take a look at our promotional sales, on a year-over-year basis, they're growing. And it's another indication that we're -- our gross margin investments are fine at this point in time. And again, we evaluate this on an ongoing basis and our overall price position relative to the channel and non-channel remains competitive similar to prior periods.

Ravichandra K. Saligram

Yes. I've got one last thing I'd say, one of the key drivers of gross margin also is we've put a lot of emphasis, and will continue to put emphasis, on private label. And that's a key driver and sourcing from Asia, all of which enhance gross margin, without having to sacrifice the competitiveness to drive consumers in.

Oliver Wintermantel - ISI Group Inc., Research Division

Thanks. And maybe I can slide in a second one. You said sales from existing customers were down about 4.6% in the first quarter. Can you remind us what that ratio was? Or how much it was down in the previous few quarters?

Ravichandra K. Saligram

John, do you want to tackle that?

John C. Kenning

Sure, Ravi. This is John Kenning. Our existing sales to our customers was down. As you're very aware from our last few calls, we focused heavily on our existing customers, looking at retention, which Ravi mentioned was at 92%. Our existing base was down 4.6% in this quarter. Last quarter, it was down 4.7%. That was adjusted down -- would be adjusted downward for weather last quarter, from Sandy the hurricane. But overall, we see a slight improvement quarter-over-quarter.

Ravichandra K. Saligram

But I think one of the things that has happened, Oliver, is that the first half of last year, we really had improvements with our existing declines. And I think starting sort of in third quarter, and it really accelerated in fourth, that the existing declines got exacerbated and accelerated which we're seeing the continuation. Part of it, I think fourth quarter, aside from the Sandy effect, was that you have the fiscal cliff. And I think this whole uncertainty started with the fiscal cliff and we're seeing that sort of continue. And given that we have a high preponderance of large and enterprise accounts, that affects us more in the balance because -- and that's one of the reasons where we are really driving the whole SMB effort because, over time, we want to change that mix.


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

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

And we've got 2 questions. First of all, if you could expand a bit more on the investments that you're making in the Contract side, those seem to drive most of the shortfall versus our forecast. And if you could relate, please, how sustained you expect those investments to be, in other words, will you see investments at similar levels over the next several quarters?

Ravichandra K. Saligram

So Matt, let me kick it off, and then John or Bruce can also add to it. So in terms of -- first and foremost, I still have a huge amount of confidence in our whole Contract business. And I think the strategies we put in place 18 months ago have really been very sound. And the fact that we have maintained our retention rate at the 92% plus [ph] level is a testimony to how our associates continue to build relationships with customers and drive our service levels. The investments we made clearly have been on our growth adjacencies, the small business, small and medium business effort -- initiative has clearly been an important investment, which is very important for us to change our longer-term mix, because it's higher margin, and we are seeing the higher margins. Also, as I mentioned in our prepared remarks, we -- our new account acquisition in SMB is continuing to progress in the 12 markets that we rolled out. We also made investments in developing and growing our -- some of our growth adjacencies. Our facilities products are essentially cleaning, break room and facilities, which we grew again double digits. So I think the adjacencies there have been a good one. Furniture has been another area that we put emphasis. I think through 2012, we had good traction as we did in parts of '11. In the first quarter, we experienced some softness in furniture, but the trends we are seeing show, again, a pickup on the furniture side. So -- and then finally, one of the big investments has been in our whole digital side on the Contract website on our, which has been, I think, a terrific investment and we are getting very positive customer reactions from those. So those would be some highlights. John, anything you want to add?

John C. Kenning

Ravi, I think, the key one was SMB that you talked about. We are expanding markets from last quarter. We entered into additional 4 more, the 12 markets you mentioned. We've had nice double-digit growth in the facilities products and services business. We made nice investments in increasing our capabilities in that marketplace and continuing to go direct with some of our direct vendors there, we've increased our capability. And then, I would say, overall, in the furniture business, we've seen great results in the last couple of months from a backlog so we're starting to see the trends, overall, in those 3 adjacencies continue to grow as you mentioned.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

And without getting too specific on the numbers, this was the first quarter of outright expense growth in the Contract business since the first quarter of 2011, I believe. Would you expect and then as part of your guidance to deleverage that the dollars would remain higher year-on-year or was this a bit of an outlier?

Bruce H. Besanko

Matt, this is Bruce. What I would say is that the guidance that we're going to continue for -- on a consolidated basis, that to deleverage although, I imagine on the absolute dollar level, it will be flat to slightly down for the full year. We're going to continue to make investments though in the business. We're going to continue to invest in the transformation that Ravi's talked about. And just one other add is that all of the digital initiatives affect the Contract segment.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

And sorry, I already asked my -- I'll put my earlier question on the table just very briefly. You spoke about a slower implementation of new account wins. And I wonder what's the effect of the merger, which is clearly well known and well understood by the business community, might be having either on new business wins or on new account implementations as we speak?

John C. Kenning

So naturally, anytime you go through a merger, you're going to see a lot of questions from our customer base. We think we've done a very strong job of answering those around the merger, our efficiencies. We've seen in our existing base an upswing, both internally and with new customers in the first quarter of 2012 -- or, excuse me, 2013, that we'll be implementing as we speak. So we feel good about the rest of the year as far as new customer acquisition. We're starting to see the transition, we're starting to see our customers. But the big thing is, as Ravi mentioned earlier, in the existing base, we continue to work on that and drive that. Our mix, from an enterprise standpoint, and their caution right now in spending has been the biggest effect on the business in the first quarter.

Ravichandra K. Saligram

So Matt, to be very direct, we don't think that the new business implementation slowdown is related to the merger. So these, for new business wins, because it takes usually 30 to 60 days, 90 days, depending on the accounts, these were accounts that were won in the fourth quarter. I think, we think, the implementation issue is more related to the economy and some of the things that people are seeing slower to make decisions. And so the implementation-specific issue, we don't think was necessarily related to the merger. But as John said, clearly, you'll always have some competitors who will try to take advantage of these situations. But we don't think that was related to the implementation side.


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

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

Wanted to ask just about the sort of the leverage sensitivity of the business, if you will. Ravi, obviously, in your prepared remarks, you mentioned how, in 2012, the company grew earnings and EBITDA, and this, of course, came despite declines in sales in both the Contract and Retail businesses. In each of those 2 segments, I mean, what are the revenue declines that the company's able to sort of stomach and still be able to generate some EBIT expansion, based on the current cadence that you're looking at today?

Ravichandra K. Saligram

So Bruce, why don't you tackle that? Though I just want to clarify one thing. In 2012, while we had clearly revenue declines in the Retail side, U.S. Contract, as I mentioned in my prepared remarks, when you extract out the 53rd week, it actually grew as a segment, and our digital initiatives, which are embedded in that, also grew double digits. So I think it was 2.3% or so that I mentioned in the business. So we did have -- the sales growth did help us on the Contract side. So with that, I'll have Bruce answer your question specifically.

Bruce H. Besanko

Brad, let me just take a step back. We obviously saw weakness beginning in the fourth quarter last year, we actually saw it continue into the first quarter, particularly in the first half of the quarter. And as Ravi said, we think that there is -- it's largely attributable to the significant uncertainties in the macroeconomic area. We have done, historically, a great job of taking out both fixed costs and, certainly, variable costs as the sales have come down. But in the first quarter, the sales decline was -- the 5.7% decline in the first quarter, on a consolidated basis, was simply too much for the P&L to withstand, given the deleveraging both in our gross margin and in our SG&A. But what I would tell you is that, if history's any measure of what we are capable of accomplishing, we can, as we see the revenues decline, we can take out sufficient levels of cost so that the P&L stays healthy. Unfortunately, just in the first quarter, given the level of declines, we weren't able to do that. But the consequence of what we saw in the first quarter is that we're going to take out and have taken out planned costs for the remainder of the year. We expect that, that will help the P&L. And relative to our earlier expected levels of investment, those have now -- we're now planning those down.

Ravichandra K. Saligram

Brad, just to finish what Bruce said, for the remainder of the year, the management team went into action when we started seeing this. And so we've identified -- this management team has, I think, a real competency in finding the next level of cost reductions. And we put a plan in place, and which is why we said that, in the second half of the year, in the press release, that we expected, and as Bruce said in his prepared remarks, that we'd improve the profit trajectory. So to us, the 2 levers when you can't drive the sales lever, we look to the gross margin lever and the cost reduction lever. And I think we've proven that, time and again, that's something that this management team is good at, while we continue to try and find a solution to restoring top line growth.

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

That's helpful. And if I can just ask a follow up on the government sales, could you just remind us how big that is as a percentage of business today? And maybe talk a little bit about what your expectations are, going forward? Could we get another leg down as this sequestration kicks in to a greater degree?

John C. Kenning

So we don't publish exactly the numbers from our government business. It is a substantial portion of our business, and really the public sector, in total, is and we are watching it very closely. We're going to continue to make the right changes in the business, to management, both from a top line and a bottom line standpoint, in the Contract organization. We are seeing some opportunities in that business and we'll continue to look at those. But it's a tough sector, as you're very aware of today. And we're going to continue to manage it in the proper fashion.


And your next question comes from the line of Michael Lasser with UBS.

Michael Lasser - UBS Investment Bank, Research Division

Two of them. First, on the cost reductions that you're implementing. Does that draw away from the potential synergies that you're expecting to achieve with the merger of Office Depot? And if not, were these buckets -- where are the buckets of cost reductions coming from that wouldn't touch the anticipated synergies?

Ravichandra K. Saligram


Bruce H. Besanko

Michael, Bruce here. Here's what I would say about the synergies. We announced and I remain committed and confident in the delivery of the $400 million to $600 million of synergy. Certainly, there are significantly more synergies available to a combination of 2 companies than there are by one independent company. I feel very good about the synergies. I don't think that there's any reason to believe that we're not going to deliver on the $400 million to $600 million. I remain very confident and feel very good about them.

Michael Lasser - UBS Investment Bank, Research Division

But you're not able to provide more detail on where some of the cost reductions are coming from?

Bruce H. Besanko

Well, the cost reductions that we've talked about are typically in some of the initiative spending that we had earlier planned for -- for the year. There will be areas of investment that we're simply -- we're just not going to do this year. We've deferred them into later quarters or perhaps next year. But that's where the most significant portions of the cost reductions are coming from. Now we also have variable expense that will come out of the business as the P&L -- if the revenue moves lower and so variable expense will go out as well.

Ravichandra K. Saligram

Michael, I think part of it, one on initiatives, now that we've had about 1 year, 1.5 years, of driving these, the results have given us a window on a sense of which ones are more productive than others. So we've done some reprioritizing, which allows us to trim down some of the investments there. Secondly, remember, last year, we started, again, looking at our international businesses, Australia and New Zealand, where the synergies -- Canada and the U.S., and those continue to remain fertile grounds for us as we look at the next level of efficiencies. So as a management team, we just are constantly looking for ways of driving cost reductions. And we think that there is a set of cost reductions that we can drive ingeniously within -- being independent. Then there's a whole bucket that you have when you merge 2 companies, and we don't see these 2 as -- I think we can do both and we remain very confident of both of those.

Michael Lasser - UBS Investment Bank, Research Division

Okay. Well, Ravi, Let me just follow up, one quick question on the operating environment. You said it's sequestration, pill taxes and health care as issues that are weighing on the environment. Seems like all those sectors are probably going to get a lot worse before they get better. So do you think that this environment is kind of a new norm? And within that, are you holding share, losing share? And what can you do to maintain your position if that -- if the current environment holds?

Ravichandra K. Saligram

Well, I think -- we've operated and with assumptions that the economy doesn't really give you tailwind. Now if there is some sort of a silver lining here, at least the April jobs report was slightly encouraging and that consumer confidence went up, but we try to be even-keeled about it and just assume that and say, "Hey, let's focus on what you can control." So I think, with that, when we look at 2012 as a whole, when we look at the Contract business, we felt we had some share gains in there. In first quarter, we saw some of that, we sort of saw some loss of that share. So you've got to look at the overall trend. I think, the key here, for us, is how do we -- we've got to find the lever on getting that top line growth, and I think, all those innovation initiatives that we've talked about in Retail, as well as our growth adjacencies in Contract and then driving digital, which we really think is the future, is what's going to really get us over time. And one of the things in terms of longer term, the some of the structural issues of the industry which is why we embarked on this merger in the first place.


And your final question comes from the line of Gary Balter with Credit Suisse.

Gary Balter - Crédit Suisse AG, Research Division

You took a $25.3 million charge for store closings. Does that cover the $15 million to $20 million that you talked about for the year? Was that the 5 U.S. and the one Mexico, just to give us some context or what stores counts to close?

Bruce H. Besanko

Gary, I think -- this is Bruce. I think that, that number may be reflective of prior year.

Gary Balter - Crédit Suisse AG, Research Division

Okay. Because that -- wasn't that in this quarter or is that last year?

Bruce H. Besanko

No, I think it was last year, Gary.

Gary Balter - Crédit Suisse AG, Research Division

Okay, sorry. Could you talk a little bit about any surprises that you got, if any, in the second request or was it pretty much as you would have expected?

Ravichandra K. Saligram

Yes, Gary, on the second request. First, we anticipated that. And we have -- we are using Dechert [ph] which we talked about. They're really an outstanding firm with great relationships with FTC. We don't -- everything is proceeding according to plan and so, no.

Gary Balter - Crédit Suisse AG, Research Division

Okay. I think Matt had asked the question about maybe some of the weakness reflex, just people, clients anticipating the merger. Have you seen any turnover in your sales force or other behavior that may be impacting the business as well?

Ravichandra K. Saligram

So Gary, we're putting a tremendous amount of effort on retention of our associates, keeping them engaged. And the ultimate testimony to me is the 92%-plus customer retention, which you know in this industry is not easy. And the fact that, that we've held that, and in terms of other than normal turnover, we've not seen any sort of mass exodus. Our teams really understand why we've taken great pains to understand the rational for the merger, the structural issues in the industry and how this really -- we're going to create a new company, that is about thriving and can really reposition itself and yet we'll just have more firepower to drive a lot of the innovations that we talked about. So no, we feel pretty comfortable about that.

Michael J. Lewis

Thank you, Gary.

Ravichandra K. Saligram

Indeed. Is that the last question, Mike? Okay. Thank you very much for being on the call. We appreciate it and have a great day.


And that does conclude today's presentation, everyone. You may now disconnect.

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