Staples' (SPLS) CEO Ronald Sargent on Q1 2016 Results - Earnings Call Transcript

| About: Staples, Inc. (SPLS)

Staples, Inc. (NASDAQ:SPLS)

Q1 2016 Earnings Conference Call

May 18, 2016, 08:00 AM ET

Executives

Chris Powers - Vice President of Investor Relations

Ronald Sargent - Chairman and Chief Executive Officer

Christine Komola - Chief Financial Officer

Shira Goodman - President, North American Operations

John Wilson - President, International Operations and Head of Global Transformation

Analysts

Michael Lasser - UBS

Simeon Gutman - Morgan Stanley & Co.

Michael Baker - Deutsche Bank Securities Inc.

Matthew Fassler - Goldman Sachs

Christopher Horvers - J.P. Morgan

Kate McShane - Citigroup

Gregory Melich - Evercore ISI

Daniel Binder - Jefferies & Co.

Anthony Chukumba - BB&T Capital Markets

Operator

Good day ladies and gentlemen. Welcome to the Staples, Inc First Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen only mode. Later, we will conduct a question and answer session and instructions will follow at that time [Operator Instructions] As a reminder, this conference is being recorded.

I would like to introduce your host for today’s conference Mr. Chris Powers, Vice President Investor Relations. Sir you may begin.

Chris Powers

Thanks [Tory]. Good morning, everyone and thanks for joining us for our first quarter 2016 earnings call. During today’s call, we will discuss certain non-GAAP metrics. Please see the financial measures and other data section of the investor information portion of staples.com for a reconciliation of these measures.

Certain information w will discuss constitutes forward-looking statements for purposes of the safe harbor provisions of The Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by such forward looking statements as a result of various factors including those discussed or referenced in Staple’s 10-Q filed this morning.

Here to discuss Staple’s Q1 performance, outlook and strategic plan are Ron Sargent, Chairman and Chief Executive Officer and Christine Komola, Chief Financial Officer. Also joining us are Shira Goodman, President, North American Operations and John Wilson, President International Operations and Head of Global Transformation. Ron.

Ronald Sargent

Thanks, Chris, and good morning, everybody. Thanks for joining us today. This morning we announced our first quarter results that were right in-line with our expectations. Before I discuss Q1 in more detail, I would like to start-off by covering some recent headlines relating to two topics, one is our attempted acquisition of Office Depot, and two, is our strategic plan going forward.

I think everybody on the call knows that last week the U.S. District Court, District of Columbia granted the FTC’s request to block our acquisition of Office Depot. We were disappointed that the FTC’s request was granted despite the fact that in our view it failed to define the relevant market correctly and fell short of proving its case.

The FTC excluded ink and toner from the market definition of consumable office supplies. They only focused on Fortune 100 customers and acknowledged that there were no concerns about any harm to consumers or small or medium businesses. The FTC ignored the competitive threat from Amazon business and a host of other competitors and also encouraged witnesses to say things that weren’t true to bolster their case.

We are also disappointed that our proposed remedies to satisfy the FTC’s concerns were unsuccessful and that our commitment to invest a significant portion of the synergies at lower prices for all customers was not heard. We pursue the Office Depot acquisition to provide increased value to customers, to compete more effectively against the large and diverse set of competitors and to generate tremendous value for our shareholders.

Over the past 20-months, we have committed a lot of time and resources to getting the deal done. Given the additional time and resources we’d have to commit to pursue an appeal, we have determined that it’s in the best interest of our shareholders to forego appealing the court’s ruling. Earlier this week we terminated the merger agreement with Office Depot and we will pay the $250 million breakup fee tomorrow. Our divestiture agreement with Essendant also terminated in connection with the termination of the Office Depot merger agreement. And finally, I would just like to thank both Office Depot and Essendant for their hard work and for the collaboration as we pursued this transaction.

We are now focused on moving forward and we are focused on executing our strategic plan to drive shareholder value for what we are referring to internally as Staple’s 2020. This plan builds on our reinvention successes over the past few years and it is supported by our strongest competitive advantages.

We have had good success driving growth in categories beyond office supplies and in growing our mid-market contract business. We have also been challenged by weak results in Europe and in North American stores. We are confident that by narrowing our focus we are aggressively pursuing our best opportunities, accelerating growth in our asset-light businesses and pulling back in areas with less potential we can get back to sustainable long-term sales and earnings growth and significantly improve return on net assets.

Our strategic plan includes four key priorities. First, we are focusing on winning with mid-market customers in North America by accelerating growth in services and products beyond office supplies. Second, we are reshaping Staples by narrowing our focus on North America right sizing our retail network and exploring strategic alternatives for our European operations. Third, we are taking aggressive action to reduce cost and drive efficiency further across the organization and fourth, we are continuing to return cash to shareholders through dividends and share repurchases.

Few months ago, we streamlined our organization to build a simplified structure, speedup decision making and provide flexibility to invest in our critical, strategic objectives. The changes we have made have set us up for success. With Shira Goodman leading our North American operations and John Wilson overseeing our international operations and our strategic planning and transformation efforts, I’m confident that we have the right team in place to win with customers.

Over the next three-years, we will dramatically change the profile of Staples as we position our company for the future. More than 95% of our sales will come from North America versus about 85% today. About 80% of our sales will be delivery versus 60% today and sales beyond office supplies will account for more than 60% of our revenues versus less than 50% today.

Let me take a few minutes to give you a little more color on each of our four priorities. First, winning with mid-market customers in North America. We define the mid-market as business customers with 10 to 200 employees. This is a highly profitable and highly fragmented customer segment and today we have very low share with mid-market customers and categories beyond office supplies.

The needs of those mid-market customers align closely with our strengths. These customers need a wide assortment of products and services, the support of category specialists who have expertise and easy online shopping experience as well as quick and reliable delivery. We have expertise in a wide range of products and services. We have a world-class supply chain and next day delivery capability. Our digital expertise provides a differentiated customer experience.

We have a new mid-market loyalty program that is driving increased spend, high retention rates and increased customer engagement and we recently rebranded our B2B division Staples Business Advantage to emphasize the many advantages that we can provide to those business customers.

To accelerate growth in the mid-market we have developed a strong customer focus plan that builds on these strengths. Our plan focuses on increasing our share of wallet with hundreds of thousands of mid-market customers we serve today and on acquiring many of the mid-market customers that we don’t currently serve.

We are increasing our offerings of products and services beyond office supplies and pursuing market share gains in core categories like office supplies, ink, toner and paper. We are investing in sharper pricing and enhanced supply chain capabilities.

We are dramatically expanding the size of our mid-market sales force with the addition of more than 1,000 new sales reps and we are also pursuing acquisitions of B2B service providers in companies specializing in categories beyond office supplies. In summary, we are helping smaller mid-market customers compete like a Fortune 500 company.

Second, we are reshaping Staples to reduce risk and preserve profitability. John Wilson and the leadership team in Europe have worked tirelessly to streamline and stabilize Europe over the past few years. While we believe there is a significant opportunity to generate value in the highly fragmented European market, we also recognize that our best growth opportunities are in North America and that these are our primary focus.

As a result, we have decided to explore strategic alternatives for our European operations. Over the coming weeks, we plan to meet with potential buyers of our European operations and we will provide more details on timing and valuation as we work through this process.

We also remain committed to increasing productivity and preserving profitability in our North American retail stores. We have closed more than 300 stores and reduced our lease obligations by more than $1 billion in North America since 2011. We have also aggressively managed our lease renewal process. Today, our average remaining lease life in North America is about 3.5-years per store. That’s a reduction of more than 40% since 2011.

We challenged the retail stores to do more with less and they have delivered. Customer service scores remains strong and customer conversion is at an all time high. We will remain laser focused on these metrics going forward. We will also continue to right size our retail store portfolio in North America by closing at least 50 stores this year.

In addition to closing on productive stores, we will continue to build on the strength of our Omni-channel capabilities and services like copy and print. We believe our store provides convenient and immediacy that is valued by customers of all sizes including mid-market customers.

Our third priority is to aggressively reduce cost across the company to drive efficiency and fund our growth investments. Over the past three-years, we have generated approximately $750 million of annualized pre-tax cost savings by evolving the business processes, increasing productivity and developing more efficient ways to serve customers.

Last week, we announced a new multi-year cost savings plan, which is expected to generate an additional $300 million of annualized pre-tax cost savings by the end of 2018. We are focused on reducing product costs, optimizing promotions, increasing the mix of Staples brand products and reducing operating expenses. We will also continue to reduce costs in retail stores as we right size our store network.

Our fourth priority with the continue returning cash to shareholders. We remain committed to our ongoing cash dividend program; we plan to resume repurchasing our common stock through open market purchases during the second quarter of 2016. We are currently planning for share repurchases of approximately $100 million in 2016.

As the industry leader, we pursue the acquisition of Office Depot from a position of strength. We are now pursuing our strategic plan from a similar position; we are dramatically reshaping our business, while increasing our focus on category beyond office supplies and evolving to meet the changing needs of mid-market customers. We are reducing our exposure to underperforming businesses and we are reiterating our commitment to return cash to our shareholders.

Now, let’s turn to our first quarter results. Total company sales for Q1 were down about 1% year-over-year, excluding the impact of store closures and changes in foreign exchange rates. Non-GAAP operating income rate in dollars improve versus Q1 of last year, non-GAAP earnings per share of $0.17 was flat versus Q1 of last year.

On our Q4 earnings call, we talked about our key priorities for 2016, which are now a critical part of our strategic plan. Let me take a few minutes to give you some color on our progress during the first quarter. One of our top priorities is to accelerate growth in categories beyond office supplies. Today, nearly half of our sales or generated beyond office supplies, and business customers are increasingly relying Staples to provide them with a wider assortment of products and services.

The market for these categories is highly fragmented and we are winning with business customers of all sizes by providing a differentiated level of services and expertise. During Q1, North American contract continue to lead the way here with growth in promotional products, facility supplies, break room supplies, technology and furniture. We also grew key categories beyond office supplies in North American stores and online during Q1 with comparable sales growth in furniture, facility supplies copy and print, mail and ship and break room supplies.

Another priority is to grow our mid-market penetration in contract. During Q1, we grew North American contract sales by 2% in local currency; our strongest momentum was in the mid-market where sales were up in the mid-single-digits driven by sales beyond office supplies which is up about 10% year-over-year. Improved customer acquisition and retention offset modestly lower sales through existing customers and this was supported by additional mid-market sales reps that we hired during Q1, as well as continued strong performance in our mid-market membership program.

We also narrowed our focused on our best growth opportunities in contract during the first quarter with the announcement of our intention to sell our contract print manufacturing and operations business to Taylor Corporation. We acquired the contract print business when we brought Corporate Express in 2008, as we increased our focus on growing our asset-light businesses and improving return on net assets that makes sense for us to parkways with contract print.

At Staples, we like to scale and manufacturing expertise that this business requires, the business is also very capital intensive generates an operating margin below the house and generates return on net assets below our costs of capital. While this business isn’t a great fit in the Staples portfolio, it’s a perfect fit Taylor. We expect to deal to close during the second quarter; we look forward to continuing to offer a wide assortment of print solutions to our contract customers through vendor partnerships and our own in-store running capabilities.

We are also focused under improving traffic both in-store and online. Results here have been mixed during the first quarter. In Canada, traffic and stores an online increased year-over-year and we improved customer conversion. In the United States, we also improved customer conversion in-stores and online, but this was not enough to offset lower customer traffic across both channels.

We remain committed to improving customer traffic online and conversion in-stores. A few weeks ago, we launch a new unbeatable prices for ink and toner and while it’s still early I'm pleased report the customer feedback has been very positive and we have seen a nice improvement in online traffic in the U.S. during the first few weeks of Q2. We know this is the right decision to improve price perception while driving business customer acquisition and retention over the long-term.

Over the past few years, we have had success driving and categories beyond office supplies, growing our mid-market contract business and providing better value for our customers by investing in lower prices. Our momentum continued during the first quarter, our strategic plan is supported by our strongest competitive advantages and builds on these successes. We are confident that by narrowing our focus and more aggressively pursuing our best opportunities, we will speed up our transformation while positioning Staples for sustainable long-term sales and earnings growth.

Let’s take a quick look at first quarter results from each of business units. So I’m going to start with North American Commercial. Here, sales were up 1% year-over-year excluding the negative impact with changes in foreign exchange rates. On a GAAP basis, sales in U.S. Dollar were flat versus Q1 of last year at $2.1 billion. In contract, sales grew 2% in local currency during the quarter.

As I mentioned a few minutes ago, we continue to drive strong growth in categories beyond office supplies and contract during the first quarter, we achieved double-digit growth in promotional products and break room supplies and sales were up in a high single-digits in facility supplies. Contract sales in core categories like ink and toner and paper were down in the low to mid single-digits and sales of office supplies were flat versus Q1 of 2015.

During the first quarter, North America’s commercial operating margin increased 63 basis points to 7% and operating income grew by approximately $14 million or about 10% year-over-year. This improvement primarily reflects lower labor costs and reduced marketing expense. We expect the divestiture of Staples’ Print Solutions to close over the coming weeks and as a result of the sale, we are planning for about 4% headwind to our reported North American commercial sales and about a 2% headwind to our reported total company sales over the next year.

Turning toward North American stores and online sales declined approximately 2% excluding the negative impact of changes in foreign exchange rates of store closures. On a GAAP basis they were down 5% $2.2 billion versus Q1 of last year. During the first quarter, combined North American stores and online comparable sales declined by 3% this reflects a 1% local currency sales growth at staples.com and a 4% decline in same-store sales. Results in Canada were stronger than the U.S. in both stores and online during the first quarter.

From a category perspective, the 3% decline in comparable sales during Q1 was entirely driven by ongoing weakness in technology, as well as weakness in ink and toner and technology - tablets and technology accessories where our weakest categories were double-digit decline year-over-year, ink and toner was down in the low single-digits. Outside of technology and ink and toner, comparable sales in-stores and online grew during the first quarter. This growth was driven by furniture, office supplies, facility supplies and copy and print.

North American stores and online operating margin decreased 40 basis points year-over-year to 2.8%. This primarily reflects the negative impact of lower sales on fixed expenses as well as lower product margins at staples.com versus Q1 of last year. This was partially offset by reduced marketing expense, improved retail product margin rate and savings related to reduction in headcount.

We continue to right size our retail store network in North America. During the quarter, we closed 14 stores in the United States ending Q1 with 1,288 stores in the United States and 305 stores in Canada. We have now closed 256 stores or about 14% of the North American chain since 2014.

Finally turning to international operations, our sales here decreased 3% excluding the negative impact of changes in foreign exchange rates, on a GAAP basis sales in U.S. Dollar were down 6% year-over-year to 738 million versus Q1 of last year. In Europe, retail same-store sales declined 9% during the first quarter driven primarily by decrease in customer traffic versus Q1.

In our contract business in Europe, local currency sales were down in a high single-digit during the first quarter. In our European online business in local currency, sales were down in the low single-digits. Despite the weak sales trends in Europe during the first quarter, John Wilson and his team in Europe did a great job aggressively managing expenses and in fact drove improved profitability year-over-year.

Outside of Europe, we continue to drive solid growth in China during Q1 with sales up in the strong double-digit range in local currency versus Q1 of last year. We also continue to make progress improving the bottom line in Australia, New Zealand as well as China. On the bottom line, international operating margin rate improved 13 basis points versus Q1 of last year to an operating loss of 2.4% and this was driven by year-over-year improvement in Australia, China and in Europe.

And with that, let me turn it over to Christine to review our financial results. Christine.

Christine Komola

Thanks Ron. Good morning, everyone. Total company sales for the first quarter were $5.1 billion, on a non-GAAP basis, total company sales declined 1% versus Q1 of last year. This excludes a 1% headwind from changes from changes in foreign exchange and a 1% headwind from stores we closed in North America during the past year. On a GAAP basis, sales declined 3% versus Q1 of last year.

During the first quarter, we achieved non-GAAP diluted earnings per share of $0.17, which was unchanged versus Q1 of last year. Our Q1 2016 non-GAAP diluted earnings per share excludes pre-tax changes of $66 million primarily related to costs associated with the proposed acquisition of Office Depot and store closures. It also excludes a pre-tax charge of $32 million related to the pending sales of Staples Print Solutions.

On a GAAP basis, we reported net earnings of $0.06 per share. Gross profit margins for the first quarter decreased 33 basis points to 25.3% versus Q1 of last year. This primarily reflects lower products margin rate in international operations and it was partially offset by improved products margin in North America stores.

During the first quarter, total company SG&A decreased $59 million year-over-year after excluding a $24 million charge in Q1 of this year primarily related to the proposed acquisition of Office Depot, or $11 million of acquisition related cost and $4 million of accelerated depreciation during Q1 of last year.

This reflects lower labor cost with a headcount reduction and store closures lower marketing expense and the favorable impact of the stronger U.S. dollar. As a percentage of sales, SG&A excluding charges decreased 44 basis points with 21.5%. Excluding the impact of charges, non-GAAP total company operating margin rate increased 14 basis points year-over-year to 3.4%.

Turning to our Q1 tax rate excluding the impact of charges, our non-GAAP effective tax rate was 35.5% versus our non-GAAP effective tax rate of 33.5% in Q1 of 2015. This modest year-over-year increase in our effective tax rate was primarily driven by changes in our geographic mix of earnings versus 2015.

Q1 capital expenditures came in at $44 million, a decrease of $16 million versus the prior year with operating cash flow of $276 million, we generated free cash flow of $232 million during the first quarter. During the first quarter, we did make cash payments of $69 million, related to the Office Depot financing commitment fees earned by our lenders in 2015.

If you exclude the negative impact of these payments, our first quarter free cash flow came in at $301 million. At the end of Q1, Staples had approximately $2 billion in liquidity including cash and cash equivalents of $946 million and available lines of credit of about $1.1 billion. As Ron mentioned at the beginning of the call, one of our top priorities is to continue returning excess cash to shareholders.

We return more than 300 million to shareholders annually through cash dividend and we remain committed to our dividend program. We also plan to resume share repurchases during Q2. Our current forecast is for about $100 million of share repurchases in 2016. As a result, we plan to return approximately $400 million of shareholders this year through dividends and repurchases.

Now turning to our outlook, we remain on-track to get back to earnings growth in 2016. During the second quarter, we expect total company’s sales to decrease versus Q2 of last year, we expect to drive growth in categories beyond office supplies and our contract businesses in North America. This will be offset by the headwind related to the sale of Staples Print Solutions as well as ongoing weaknesses in technology in our retail stores and store closures.

On the bottom-line, we expect second quarter non-GAAP diluted earnings per share in the range of $0.11 to $0.13. Our earnings guidance excludes remaining cost associated with the proposed acquisition of Office Depot and the impact of ongoing store closures as well as the negative impact of the Office Depot breakup fee. We expect to generate approximately $600 million of free cash flow in 2016. Our free cash flow guidance excludes the impact of cash payments related to acquisition financing as well as the impact of the breakup fee that we will play Office Depot this week.

In 2016, we plan to close at least 50 retail stores in North America. Overtime, our strategic plan will drive improvements in both the top-line and the bottom-line. We will experience sales pressures as we explore strategic alternatives in Europe and as we continue to close retail stores in North America. These headwinds will be offset by mid-market growth fueled by the categories beyond office supplies.

We expect to get back to sustainable earnings growth as we reshape Staples and resume our entry purchase program. We also expect stable free cash flow and a significant improvement in return on net assets as we increase our focus on asset-light businesses and reduce our exposure to our weakest performing businesses.

I will now turn it back over to our conference call moderator for Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Michael Lasser of UBS. Your line is now open.

Ronald Sargent

Good morning Michael.

Michael Lasser

Hey Ron. Good morning. Thanks a lot for taking my question. So Ron it seems like in the week of the ODP situation, the strategy is now just to return to what were the areas of focus that were in place prior to the deal, in ship away what you had been working on whether it’s paring costs, growing categories beyond office supplies. How do you know that that’s the right strategy or at least you are pursuing that strategy at the right pace? Why not more aggressive actions and steps be the right path to pursue?

Ronald Sargent

Well, let me just give you a couple of things, the reason we are pursuing this is because we took a good hard look with a lot of inside and outside help of, John and Shira have been involved in this project for the last several months with some outside resources as well, and we looked at kind of where do we compete best, where are our strongest competitive advantage is, we looked at not only today but also kind of down the road and basically it builds on some of the things that we have been very successfully at over the last several years and whether that’s kind of the opportunity of mid-market customers where we think there is a great opportunity to, one, get more of them as well as more sell more to them, whether that’s getting focused as more of a delivery asset-light company versus an asset-heavy company, and we've talked about what we are doing with retail stores and what we have done with retail stores, whether that talks about making really a tough decision about looking at opportunities and options relating to our European business, and I think in our situation, in a declining industry, cost out is something we have to continue to do and we have done a pretty good job as well. So I think those are the elements of the strategy. I mean, I’m sure anybody can say you are being too aggressive or not aggressive enough about particular part of the strategy. But I think we also in a competitive situation, we are also looking to see how our competitors respond going forward and we’ll adjust and act appropriately going forward.

Michael Lasser

And my follow-up question is, I think we have an easier view on where we think ultimately your sales will level off judging by the performance of the various segments. What is harder for us to grasp is, how significant are the pools of discretionary expenses that you could potentially reduce further from here and how do you balance reducing expenses with the need for growth. Couple of years ago, you invested a lot and you slowed the investment to try and realize a return on investment. What is the strategy [from here] [ph] how big is the bucket and where do you go from here?

Ronald Sargent

Well, when you are over $20 billion of revenue all the buckets are large. Obviously product bucket is the biggest bucket of the product costs and we think owned brand represents a real opportunity for us to take costs there. Look at our second biggest costs would probably be in the whole supply chain area and we are looking at a lot of different ways of approaching supply chain and at some point you want to know more about that sure we can respond to that.

So yes, the buckets are large and it is always a balancing act. I think we said three-months ago that we expect to get back to earnings growth this year after three or four or five-years of reduced earning year-over-year as we have invested in the business. And I think this year is the year we said we are going to grow the bottom-line, do we expect to start growing the top-line again? I do think that’s true. But as Christine said, we don’t expect to do that this year. So it’s a balancing act and the buckets of opportunity are large.

Michael Lasser

And Christine you mentioned that the North American product margins were up year-over-year in the first quarter. Was that just due to the lower penetration of technology or in a like-for-like basis were merch margins up? Thank you so much.

Christine Komola

It was actually a couple of things. One is, yes, it was partly mix, but it was also to the point we have done a lot of hard work in looking at our promotional strategy. So getting more targeted on the types of promotions that we have out there and being able to move more of those dollars to everyday low prices and particularly online. So we have been able to figure out how to really balance that type of marketing campaign.

And I would say that the U.S. retail has done a lot to grow their services business over time as well. So I think it’s all of those things coming together in that way to Ron’s point on the large pool. There are a lot of large pools and we do have a variety of ways that are starting to take hold that we will be able to pursue even more aggressively.

Michael Lasser

That’s very helpful commentary. Thank you so much.

Ronald Sargent

Thanks, Michael.

Operator

Thank you. Our next question comes from Simeon Gutman of Morgan Stanley. Your line is now open.

Simeon Gutman

Hi everyone, it’s Simeon Gutman.

Ronald Sargent

Hey Simeon.

Simeon Gutman

How you are doing. So my first question, it was mentioned returning back to earnings growth. Can we speak to it in terms of EBIT or EBITDA growth is that going to be positive eventually and in that same regard the $300 million of cost savings over the next few years. Is that to offset investment or is some of that going to flow to I guess to the EBIT or the bottom-line?

Ronald Sargent

Yes. Sure.

Christine Komola

Sure. So I’ll take that question. The earnings growth will come - we haven’t kind of definitively defined that yet, because we don’t want to give forward-looking guidance. So we definitely think it will be towards on the bottom line. And I think the $300 million it’s going to be a combination of things, some of it will go to shareholders on the bottom line, some of it will be used to invest in the business.

And we will be flexible and we do think earnings will grow just in normal course particularly on some of the contact businesses that you saw this quarter. So we will continue to drive this growth through the sales of those businesses as well as manage the $300 million opportunity that we’ve got.

Simeon Gutman

Okay. And then from a demand side some of the categories you sell face secular pressure, can you talk about how that curve looks today versus how it did a year ago? Is the curve steepening when you look at ink and toner and paper demand or is the rate of decline, is that holding steady?

Ronald Sargent

I think it’s relatively steady, when you look at office supplies were shrinking and now they are kind of flattish. So office supplies themselves are getting a little better. When you look at the ink, toner and paper, I think they have been down kind of in the 3% to 4% over the last few years and that’s continuing on. In terms of technology, the technology particularly in retail that rate of decline is slowing, we are still very negative, but not nearly as negative as it was a few year ago.

Simeon Gutman

Okay. And my final question on the marketing expense. I think it helped across the board, but in both of the two North American income and delivery and in-stores. First of all, how did it come down? What type of spends came down and is there a residual hit from that in other words, is that not only an impact that you could see in the near-term from less marketing, but could there be some residual impact over the next couple of quarters from it?

Christine Komola

As we looked at the marketing expenses, we've really been very scientific and used a lot more of the analytics capability that we’ve been able to build in-house. So in general, the merchants and the marketing people would always say you are going to some sales and that’s probably true. But we think that we have enough of selling opportunity with investing back in price on the online side of the hour for example and investing in some of the sales force and the digital tool for the sales force team in the contract business.

So we’ve been very thoughtful about how we manage through the usage of that spend and really driving sales activities as in a laser focused way versus kind of a generic brand focus that we’ve had in the past.

Simeon Gutman

Okay. Thank you.

Ronald Sargent

Thanks Daniel.

Operator

Thank you. Our next question comes from Mike Baker of Deutsche Bank. Your line is now open.

Ronald Sargent

Hey Mike.

Michael Baker

Hi. How are you? I wanted to ask a couple of questions about that middle-market opportunity. So can you help us by sizing what percent of your commercial business now would you consider middle-markets and any commentary on what you think your share might be there? And then a sort of follow-up is how that this initiative we are talking about sales will be different than in the past. I have been covering you for a long time and this isn’t the first time we heard about a middle-market initiative just wanted to be flush that out? Thanks.

Ronald Sargent

Just on the stat, it’s about 20% of our contract sales and I will ask Shira Goodman who has been heavily involved in this.

Shira Goodman

Yes, so first of all mid-market while it is primarily to Staples advantage that actually spread across the company and we have mid-market customers who shop in-stores through staples.com Quill and SBA. And actually that’s a lot of the opportunity, which is how do we bring the different channels together and really have a conversion of course to go much more after.

So from a North America perspective, it is closer to 10 or 15% of the total North American business. And we’re already today growing and gaining share in this market and the key on it is that these companies are large enough that they have more sophisticated needs and marketing facilities et cetera, but they are small enough that they don’t actually have the sophistication or the scale to have those in-house.

So we are seeing that value proposition of broad assortment, competitive pricing very reliable delivery plus the expertise that we bring is really enabling us to gain share both in the core, but especially in the beyond office supply categories.

Michael Baker

And so any idea of what that share is currently?

Shira Goodman

So just across the board our mid-market share is lower than it is for either small businesses or larger businesses because we've invested more on those other ends of the spectrum and the core share is still very solid, the boss is in 1% to 2% it’s fairly de minimis and it’s a huge opportunity.

Michael Baker

Okay, interesting. The follow-up question just on the Staples Print business that you are divesting so we felt it would be a 4% hit. What will it do the operating profit in the commercial business and will that be a accounted for the discontinued operation?

Shira Goodman

It will probably be negligible to the bottom line, because it is it does have a lot of capital, lot of intensity on the actual operation side of it. So we don’t expect a significant hit and it will go into - although we will probably sell it pretty quickly, so it’ll flow through discontinued or unless it’s just a complete sale in Q2.

Michael Baker

Okay. Thanks for the color.

Ronald Sargent

Thanks Mike.

Operator

Thank you. Our next question comes from Matthew Fassler of Goldman Sachs. Your line is now open.

Ronald Sargent

Good morning Matt.

Matthew Fassler

Thanks a lot. Good morning guys. My first quarter, part of that’s prior, but if you think about the decline both in marketing cost as a percentage of sale and also lower labor expenses for North America delivery and the nice margin expansion that you saw there without issuing guidance. I know you are reluctant to do. Would you say that margin expansion is feasible there over the course of the year going forward with the kind of sales performance that you put up in Q1?

Christine Komola

Hi Matt it’s Christine. Actually, I think we focus on dollar growth and so that’s kind of our emphasis here. Having said that we have had kind of nice steady return here and we expect that to continue throughout the year.

Matthew Fassler

Okay. So in other words, the investment levels have gone in such that with limited top-line that you should be able to just hold the thumb for profitability in any day.

Christine Komola

Yes, I think that’s how started to see it and you see the return coming through on some of these investments.

Matthew Fassler

Got it. Second question kind of strategically having just been through this very extended process in having gotten to the competition I guess a bit better and maybe a bit differently. Now that you have emerged from this process, any new perspectives you would be willing to offer about where you all think you have particular competitor strengths and areas where you feel compelled to improve the business relative to competition.

Ronald Sargent

Yes, obviously I won’t be talking about Amazon business specifically, but our views there haven’t changed at all. We still think they are a very strong competitors in retail and staples.com and contract. We believe that to be successful in this industry, we got to be competitive on assortment, we got to competitive on prices and deliver capabilities. And I think our differentiation going forward not only against the Amazon business, but anybody is we’re to differentiate this based on expertise that we can provide in the mid-market as well a service that we can provide the mid-market.

I think we’ve got a lot of initiatives underway that zero in on that mid-market segment. And at the same time, I can tell you I think stores still provide a competitive advantage for us. People still want to shop in-stores, online purchasing still I think in this whole country is about 20% of retail. So 80% is still going on in-stores. There may be too many stores out there and I would agree with that and I think there will be fewer stores going forward.

But I think the stores represent a competitive advantage. I think our specialized focus on the office products in mid-market is going to be competitive advantage versus others. I think when you are buying as much products as we are buying we should be able to buy very well in the industry. So there is a lot of competitive advantages I believe we have not only against traditional kind of office products players, but also I think increasingly going forward against Amazon.

Matthew Fassler

And then finally, I know in your 10-Q you walked through some of the residual cash cost associated with the merger and I know that your store closing program has cash cost associated with it. As we think about free cash flow and model it out for 2016. Christine, what is the aggregate dollar amount above and beyond your GAAP earnings and sort of traditional CapEx et cetera that we need to think about to get to a year-end cash number?

Christine Komola

We’ve got about a $100 million on average related to the restricting and kind of the other costs that are unusual. We are not including the 250 breakup fee, so we think that the $600 million is probably the right number in the kind of ordinary course of business.

Matthew Fassler

Got it. Thank you so much guys.

Ronald Sargent

Thanks Matt.

Operator

Thank you. Our next question comes from Chris Horvers of JP Morgan. Your line is now open.

Ronald Sargent

Good morning Chris.

Christopher Horvers

Thanks. Good morning everybody. Wanted to follow-up on that question. So on the competitive advantage question. This past year, Depot had a lot of challenges, signed their new contract customers. Can you talk about your ability to maintaining that edge? Have we seen a lot of resumes from their sales force over the past year, has the delayed OfficeMax supply chain integration balanced in your business. How do you think you maintain this I guess competitive gap over Depot going forward?

Ronald Sargent

Shira.

Shira Goodman

So we’ve actually looked at that gap over a couple of years and it has been pretty steady that our contract with delivery business growth 600 to 800 basis points faster than Office Depot. So I don’t think it’s a change in trend. When you look at what is driving our growth, we’ve been steady on customer acquisition, we’ve been steady on customer retention and what is really driving that Staples Business Advantage growth is mid-market customers and categories beyond office supply and neither of those I think are really core to Office Depot contract business.

Christopher Horvers

Understood. And then so okay, that’s very helpful. And then Ron can you talk about what your vision or how do you think about the number of stores, the right number of stores in North America or the United States for the office products industry. You have had some views in the past after going through this and seeing how the business has transform. How do you think about that going forward?

Ronald Sargent

Well I think the customer is going to decide how many stores should be operating in the United States and who is going to be owning those stores. I think in the past, I have quoted a number of something like 2400 stores in the office products industry in the U.S. I’m not sure that’s a bad number at all, it’s true. When you look at today, I think Office Depot operation some maybe 2000 stores maybe a little less.

If you look at Staples this morning, I think we said that we were in the 12080, 13000 range. So do I think there are too many stores, too close together? I do. And I think our opportunity is going to focus on the delivery business and kind of right size our store network. But we won’t be doing that alone, I think we will also look at kind of competitive closings as well.

Christopher Horvers

So is the strategy you talked about I think 50 more store closures this year. So is the strategy twofold way for the leases to come up and at the same time see how aggressive Depot becomes?

Ronald Sargent

I think the strategy is to kind of optimize our retail network in conjunction with other people trying to optimize their retail network. I mean if you look at half of Office Depot stores are within five-miles of the Staples store. You look at 70% to 80% of Office Depot stores they are within 10-miles to Staples store. So I think in terms of density there is probably - excluding the North East, there is probably a density issue that probably has to be resolved as an industry not just by us.

Christopher Horvers

Makes sense. And then just follow-up on the gross margin, I’m not sure if you covered this. The degradation year-over-year was actually more steep this quarter that in prior quarters and it seems like it rolled over a bit last quarter. So what is driving that because it doesn’t sound like the mix has really changed tablets they will be n down a lot. Is that the piece of closures and the rent savings basically abating?

Shira Goodman

Chris, it’s actually pretty much in line with what we expect. We did have significant improvements last year and this year it’s been a combination of the plan that we have within some areas to investing some of our prices, it’s definitely the deleverage fixed overhead costs in our retail businesses in Europe and in U.S. But it’s also product margin rate improvement in the stores and in the European stores as well as we’ve been able to optimize some of those promotional offers that we’ve had. So it is in line with our expectation and our planning strategy across the different business units. So I think that’s a little bit of what I would put the color around that.

Christopher Horvers

Okay. So as we think about that going forward, do we analyze that or is the idea invest in price and drive sales and take out costs to keep EBIT margin flattish?

Shira Goodman

It will vary by business unit. So we are definitely focused on managing as I said growing earnings, so you will see it on the bottom-line. And some business units we will invest more in price, our strategy on price is to be focused on the business units where those units and the velocity can grow the most. We are also very focused on making sure that the other line items within that gross margins including leveraging our supply chain still an opportunity for us.

Christopher Horvers

Understood. Thanks very much.

Ronald Sargent

Thank you, Chris.

Operator

Thank you. Our next question comes from Kate McShane of Citi Research. Your line is now open.

Ronald Sargent

Good morning, Kate.

Kate McShane

Hi, good morning. Thanks for taking my question. Just had one question about Europe, I know during the merger process that I think you were looking for initiatives buyers in the Office Depot piece of European business. I just wondered in terms of interest to the extent that you can talk about it. What kind of interest that you did get and how will the dynamic change now that it seems like both European businesses are probably up for sale?

Ronald Sargent

Christine?

Christine Komola

So we were definitely working with the European commission on the sale of the Office Depot business and there was interest. So I think that the office supply business over there is very fragmented, it’s very disperse across all areas. So there was interest, I can’t go into details around that at this point in time one for our business or for their business, it’s still too early. But I think that the key point is, it is a fragmented market over there, our business is getting stronger and stronger with the leadership that is managed with John and his team. So we will see and keep you all updated as the process continues.

Kate McShane

And how long are you willing to give the process, again to the extent that you can discuss it, before maybe pursuing keeping Europe as part of the business and continuing to either restrategize or reformulate business there?

Christine Komola

It’s still early in our thinking and there is definitely a variety of ways to manage the alternatives that we have got. So I think it’s still too early to put definitive timeline and specifics out there at this point.

Kate McShane

Okay, great. And then if I could ask an unrelated question to those two and it’s been talked about a little bit already but with was price investment. Can you tell us how you are thinking about how much further you have to go, how much more work that needs to be done and ultimately do you think you have to be the absolute lowest price in order to succeed and how you are balancing that?

Ronald Sargent

Yes I think Kate, it really relates to what segment of the business we are talking about, if you look at some of the largest companies in America they are already buying very, very well. When you look at our online business or our retail business, I think there are some items that we remain too high at. Online, a couple of weeks ago we announced there has been very significant reductions in prices on ink and toner, which is the most price sensitive items, or one of the most price sensitive price items for our customers.

So I think our goal is to get close to anybody out there in the price sensitive items, not saying you have to be the absolute lost, but I think you have got to be within shouting distance. And particularly, when you think about some of the other things that retail offers, there are some advantages of retail that may be customers don’t quite expect you to be absolute lowest, but the other things that retail offers allows you to be may be slightly higher.

So I think we look at pricing like everybody else does, we look at price sensitive items, we look at the elasticity of those, we look at things that are kind of medium and then we look at things that are not elastic at all. But I think in general over the last three-years you know part of the investments that we’ve made as a result of the cost take out has been to lower prices and I think we still have ways to go.

And then finally once you get into the contract area, you are negotiating prices item-by-item, in terms off-contract or on-contract and I’m not sure there is a lot more to be done there, because we’re pretty aggressively priced in the contract side of our business already.

Kate McShane

That’s very helpful. Thank you.

Ronald Sargent

Thanks Kate.

Operator

Thank you. Our next question comes from Gregory Melich of Evercore ISI. Your line is now open.

Ronald Sargent

Good morning, Greg.

Gregory Melich

Hey, thanks. Good morning. A couple of questions, really thinking about the longer term plan of getting to 80% or 60% into the commercial side of business? The way you framed it Ron was 2400 stores for the office product industry, what do you think is the reasonable number for you as you look at now?

Ronald Sargent

Yes, I’m not going to get into that, I’m not going to be sending out competitive messages about what we think our number is. I mean we talked about closing 50 stores this year, I think we talked a few years ago about closing 300 and I think with these 50 we will about at that 300. We don’t have a lot of stores that lose a lot of money. We are trying to make sure that our lease obligation is getting as low as possible, so we do have flexibility going forward. But in terms of our number of stores we are not getting there.

Gregory Melich

Okay. And I guess on the lease obligations the rent expense now seems around at $700 million. Could you let us know how much of that is in North America versus say Europe given that you are considering leading your strategic options and also my guess is the European lease terms are longer than North America is that true to the average lease?

Ronald Sargent

Yes, the average lease is a little longer John.

John Wilson

Just under five-years in Europe right now is the average lease period and the U.S. is in the mid-threes.

Gregory Melich

And of the rent expenses Europe’s higher on average per foot?

John Wilson

Yes, per foot definitely.

Gregory Melich

Okay. And then last on the other $300 million of cost reductions you guys have outlined what cash costs would there be to executing on those?

Ronald Sargent

I’m sorry. What was that question again Greg.

Gregory Melich

What cash costs would there be if any to executing on the next $300 million cost reduction plan that you announced?

Shira Goodman

We haven’t gone to that level of detail, but I wouldn’t expect it to be a significant change in that what we’ve done.

Gregory Melich

So the ratio will be similar to what we saw in the first plan?

Shira Goodman

Yes may be even and probably a little bit less.

Gregory Melich

Okay. Fair enough. Good luck.

Ronald Sargent

Great. Thank Greg.

Shira Goodman

Thank you.

Operator

Thank you. And our next question comes from Dan Binder of Jefferies. Your line is now open.

Ronald Sargent

Good morning, Dan.

Daniel Binder

Good morning. Thank you. I just wanted to go back to the initiative in terms of your mid-market, obviously I think a 1000 new sales people and focus on that part of the market squarely focuses on the independent channel. And I was wondering if you could just give us sort of a state of the industry update on the independence as you see it and whether you think it’s going to require just sheer brute force in terms of putting sales people out there or incremental price investment versus how you price that segment today?

Ronald Sargent

Shira.

Shira Goodman

So I think it is both the offering to the customer and how we approach the customers. So it is expanding our product and services so we really can offer the very full range of what they want, continuing our competitive pricing as Ron said, because we are competitive in this area and the delivery. And for mid-market actually we have some value, they like to pick it up and in-store at times, same day shipping will be leveraging our retail network as well as things like printing the same day satisfaction that is valuable to them.

And then you know the secret part is really the expertise that we bring to the mid-market customers and that’s where it’s a combination of our sales force and yes we will be adding a 1000 sales people. So really combining them and empowering them with data and digital assets and it’s really in that mix that we think we can gain share very cost effectively and differentiate ourselves from the other competitors in the market.

Daniel Binder

Those independents have largely been successful been successful with, I would probably describe as fanatical customer service and Depot is being a big organization has big customer service. But I suspect some of the mom and pop businesses out there have these long-term relationships with independence. So how do you overcome that, how do you really distinguish your service levels versus that mom and pop player?

Shira Goodman

I think we distinguish our service levels with our execution of it. Our supply chain is really going strong, their service levels and by adding the sales people that does enable more of the one-to-one personal touch that sometimes it does take to differentiate from it. The final piece that I would add to it is that increasingly our customer base is changing as well and they are becoming more digitally astute, they are used to buying online and therefore our digital capabilities, which are far outpaced the independence feelers, we see time-and-time again its really been a lever to grow their share.

Daniel Binder

Got it, great. If I could just follow-up another question, well two actually. One could you please comment on the cadence for the quarter, I know there are some retailers out there that have talked about a slowdown in April somewhere attributing it to weather which would not affect you, but some more macro type commentary so if you could comment on that. And then the last one was just regarding these BOSS categories, you have obviously outlined from that you are pursuing today. I’m just curious if there is any sort of new categories that you would be willing to share with us today that are coming up on your radar?

Ronald Sargent

Yes, in terms of the cadence for the quarter I mean we are one of those lucky retailers that had February, March, April quarter. So Easter is kind of typically always in our quarter. Sometimes it’s late in the quarter and sometimes early in the quarter. So in terms of the cadence we were affected by the Easter shift and it came back to us the following months. In terms of BOSS categories Shira.

Shira Goodman

I would say we have a very broad offering today, when you think about everything from facilities to prints, promo, tax, furniture, but one category that were particularly exciting about and is leading the path in growth rates is break room. And that is obviously coffee is the core there, but then everything that surrounds coffee including food and snacks et cetera, and it’s a real growth area. Overall, I think as companies use break room as the way to attract talent and build culture and it’s a real opportunity for us that’s paying off.

Operator

Thank you and our last question comes from the line of Anthony Chukumba of BB&T Capital Markets. Your line is now open.

Ronald Sargent

Good Morning Anthony.

Anthony Chukumba

Good morning and thanks for taking my question. I guess my first question, could you just give us a quick update in terms of sales transfer rate from closed stores?

Ronald Sargent

Sure. I think let me just give you a big picture. When we closed the store about 70% affecting other stores and that is about 30% of the time where we don’t have any store anywhere closed. So there is no transfer there. But when you look at the 70% where there is a transfer, it’s roughly 20% and I understand that Office Depot is getting a little higher transfer rate, but my guess is that stores that they are closing would be OfficeMax and Office Depot stores that are closer together. So it runs around 20% for the stores where we do have competition if you put those 30% and that we don’t have any stores close by would probably in the 15% to 17%.

Anthony Chukumba

Got it. That’s helpful. And then my last question was related to I guess this new Labor Department regulation where they are increasing the threshold of the salary for I guess employees that are eligible for over time. And I guess I am just wondering and maybe it’s too early, but I mean first of do you see this having an impact at all in terms of your North American retail stores and what steps can you take to sort of offset that?

Ronald Sargent

Yes, I mean obviously it’s very early days, so we haven’t done any math. But I can tell you that we were kind of very early on this one, because we operate a lot of stores in California and several years ago we reclassified some of those assistant managers to hourly, just because of this issue. So I think we are pretty ahead on the issue and most of our assistant managers are kind of working similar to kind of our store managers, we don’t have a lot of 80-hour a week managers types like you might have heard about in some of the press.

Anthony Chukumba

Got it. Thank you for answering my questions. That’s helpful.

Ronald Sargent

Thanks Anthony.

Operator

Thank you and I would now like to turn the call over to Mr. Ron Sargent for any closing remarks.

Ronald Sargent

I’ll just wrap up by saying thanks for joining us on the call this morning. We look forward to speaking to all of you again very soon.

Operator

Ladies and gentlemen thank you for your participation on today’s conference. This concludes your program. You may now disconnect. Everyone have a great day.

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