ACCO Brands Corp (ACCO) 2008 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second quarter 2008 ACCO Brands earnings conference call. My name is Chanelle, and I will be your coordinator for today.

(OPERATOR INSTRUCTIONS)

As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's conference, Ms. Jennifer Rice, Vice President of Investor Relations.

Good morning, everyone, and welcome to our second quarter 2008 conference call. On the call today are David Campbell, Chairman and Chief Executive Officer of ACCO Brands Corporation, and Neal Fenwick, Executive Vice President and Chief Financial Officer.

We've posted a set of slides to accompany this call to the Investor Relations section of ACCOBrands.com. These slides give a lot of detailed information to supplement the call.

Our discussion this morning will refer to our results on an adjusted basis, excluding asset impairment charges, restructuring and nonrecurring items. A reconciliation of these results to GAAP can be found in this morning's press release.

During the call we may make forward looking statements, and based on certain risk factors, our actual results could differ materially. Please refer to our press release and SEC filings for an explanation of those factors. Following our prepared remarks we will hold a Q&A session.

Now I will turn the call over to Mr. Campbell.

Thank you, Jennifer, and good morning, everyone.

Our second quarter's top-line growth was very challenging, reflecting a continuation of weak industry demand we experienced in the first quarter, particularly in our largest markets, the US and the UK. This decline was the result of weakness in consumer demand and cautious business spending across the economy. Our weakness was further exacerbated by customers aligning their inventory levels with new lower demand expectations. Clearly we are disappointed with our second quarter results and now believe that our expectations for the balance of 2008 and 2009 need to be adjusted downward and corrective cost adjustments made. I will discuss this in greater detail in a moment.

To recap, second quarter sales declined 5%. Pricing was positive, adding 180 basis points, but volume declined 11%. As in the first quarter, Office Products and Document Finishing saw the most significant declines. Kensington Computer Products was up 3%. Our operating margin declined 100 basis points as a result of the overall lower sales volume. While our synergy savings continued to grow, even during this challenging period, reduced leverage of our fixed cost base and high raw material cost offset the benefits of synergies. EBITDA and earnings per share were also down as a result.

Increasingly over the first half of 2008 it became clear the current economic downturn will be longer and more severe than we had originally foreseen. We now are planning for depressed market conditions through 2009. In response, we have taken a more conservative view of our near-term and 2009 revenue outlook, leading us to develop what we believe to be a balanced and appropriate reduction in our current cost structure.

The shared service infrastructure that we've put in place over the past 18 months allows us flexibility to dial up the degree to which our business segments share certain back-end activities, such as demand and inventory planning, global sourcing, the management and coordination of vendors, global freight consolidation and other financial and operating functions. Since we now anticipate reduced 2008-2009 sales volume, we will increase shared activities, allowing costs and revenues to be better matched.

Specifically, we believe this approach will eliminate 250 to 300 positions and enable us to consolidate two further North American facilities. These changes are not simply cost-cutting exercises. Rather, we view them as the opportunity to accelerate the benefits of system integration work we have already accomplished, further driving best business practices and simplified processes across our business on an accelerated timeline. We also believe reduced overheads will make us a more effective competitor as our customers continue to consolidate globally.

These productivity improvements are aggressive, but necessary to deal with the weaker economic environment that we face. These improvements will reduce our operating costs and appropriately size our organization for the current environment. As a result, we will net $25 million to $35 million in cost eliminations over the next 24 months, including $10 million this year and a further $10 million to $20 million in 2009. Severance and other restructuring charges of approximately $40 million to $50 million are associated with these actions through 2010.

It is important to remember these cost reductions are in addition to the previously committed synergy benefits we still expect to realize during the balance of 2008 and 2009. While we reduce costs by accelerating sharing, we will continue to selectively spend on new product development and service enhancements to support future growth. We are actually well through an initial new product development cycle and have a robust pipeline of products for Document Finishing, Computer Products and Office Products that roll out later this year and during 2009.

During the second quarter, we experienced escalating cost inflation. We have continued to see a sharp increase in raw materials, particularly in plastics, metals and freight. We are also seeing additional cost increases on Asian purchased finished goods as the US dollar has devalued. In the face of these rapidly changing conditions, we have taken proactive steps to try to protect our margins.

First, we've built inventories on certain raw materials and finished goods in late 2007 and early 2008, giving us early control of our cost structure and allowing us time to work with vendors. Second, we are working closely with all of our vendors to better manage these cost increases, in some cases negotiating them down or delaying them. And third, we are rationalizing our vendor base and consolidating our sourcing where we can to give us additional leverage and at the same time reduce our logistics costs. Fourth, we have raised our prices where absolutely required, including a selective July 2008 price increase. We have also notified customers of a January 2009 increase and potentially of a further July 2009 increase.

For now, we believe these combined sourcing and pricing actions are adequate. However, this is an area we are monitoring closely, and we are actively considering other steps to keep our costs in line.

Finally, our customer base continues to consolidate. Those of you who have been following our story know that the ACCO Brands business strategy is based on the assumption that further industry consolidation is inevitable and ultimately healthy for the industry. Of course, each consolidation brings short-term pressures as rebate programs adjust and product assortments change, but long term we believe we will benefit from our positioning as a global strategic partner for our customers.

There are four reasons I believe we stand to gain in an environment of customer consolidation. First, we have largely exited commodity product categories and built our business around premium products with strong market shares and leading brands. Second, we are focused on innovation, and as a result our product offerings are increasingly fresh, contemporary and appealing to consumers. Third, we have created effective, leveragable low-cost distribution structures in both North America and Europe. And finally, our new systems infrastructure is simplifying our business, allowing us to become a low-cost, responsive supplier of choice.

We fundamentally believe that as our customers make their strategic vendor choices we will continue to come to the fore as one of the few companies in our industry actually investing in its business and driving product innovation.

Now I will turn to the business outlook on Slide 5. These are very uncertain times in our economy. Weakness in consumer and business spending, raw material inflation and customer consolidation have combined to create an atmosphere of prolonged market volatility. All of these factors make it increasingly difficult to provide meaningful guidance.

I have already shared with your our plans to reduce costs and improve financial flexibility in light of our lower volumes. However, we are likely to experience some raw material inflation we cannot immediately pass through, particularly in the fourth quarter of 2008.

In summary, 2008 has already proven to be a difficult year to forecast. We now see our adjusted EBITDA for the year falling within a range of between $200 million and $230 million, a broad range, but necessary given market uncertainties. This translates into earnings per share between $1.03 and $1.40. Based on our current forecast, we anticipate second half cash flow of between $100 million and $120 million and do not anticipate an issue with our bank covenants when they tighten during the fourth quarter.

Finally, I would like to provide an update on the strategic review of our Commercial Laminating segment. Our initial review of this business envisaged the possible sale of the entire laminating business, which includes two separate and distinct areas -- a commercial print finishing business and a digital print finishing business. As a result of our initial bid process we learned the commercial business was more attractive to potential acquirers as a standalone entity. This provided us with the opportunity to separate the digital business and merge it into our Document Finishing group. We believe the common customer profile of these businesses should complement each other and accelerate the top-line growth of both.

We now believe the separation and retention of the digital business within Document Finishing will both yield greater shareholder value from the combination of selling the commercial business and strengthening Document Finishing. We have repackaged the commercial business and have a number of bids in house. Conversations are underway, and we are optimistic we will complete the sale process during the fourth quarter.

Now, in summary, before I turn the call over to Neal, I want to emphasize that, while we are not pleased with our current short-term results, we believe we are operating well, considering the circumstances. We recognize the current industry challenges and are successfully managing through them while positioning ACCO Brands for its next phase of growth.

At this point I'd like to turn the call over to Neal to walk you through more of the financial details.

Neal?

Thank you, David, and good morning, everyone.

As noted on Slide 7, comparable sales for the quarter were down 9% year over year, driven mainly by lower consumer demand but also 2007 lost product placements and planned business exits.

Adjusted gross margin decreased 100 basis points. The decline was largely due to lower volumes, reducing fixed cost absorption and a $2 million charge for recalls and product rework. The benefit from price increases was more than offset by significant increases in raw material cost inflation and freight increases.

SG&A margin improved slightly as the negative effect of lower sales volume was offset by a reduction of $7.6 million in incentive accruals related to both our annual and long-term performance share plans as well as lower go-to-market expenditure, which was down $1.6 million, in line with the lower sales volume. As a result, adjusted operating income declined 19% and operating income margins contracted 100 basis points.

Our adjusted tax rate for the quarter came in at 27.2%. This was slightly lower than our now anticipated full-year rate of 30%, due largely to the timing of deductions.

Adjusted earnings per share for the quarter was down 43%, to $0.12.

We had some one-time charges in the quarter. Restructuring and restructuring-related charges were only $1 million pre-tax. We also took a $62.4 million non-cash impairment charge relating to the commercial component of our laminating segment.

On Slide 8 we have provided a breakdown of our Q2 year-over-year sales change. We are still cycling through a $6 million impact from the planned business exits, mainly the sale of our MACO Label Business in 2007. We're also working through the product placements lost in 2007. These had a $13 million impact on the quarter. Once you isolate all of these items, you can see underlying sales were down $43 million, driven by lower demand in the US and UK markets. This lower demand trend has spread to mainland Europe and Canada and includes inventory reductions in the indirect channels of our markets.

Slide 9 shows the drivers of our margin improvement for the first half of year. Notably, price less material inflation still shows a year-to-date position that is slightly favorable, at 20 basis points. However, given that this was a more healthy 70 basis points at the end of Q1, Q2 clearly saw adverse increases in raw materials and freight costs.

Net synergies came in at $7 million in the quarter, in addition to $5 million in Q1. This was actually about $2 million less than it could have been as a result of the product recalls and rework.

The lower volume and reducing our inventories also adversely impacted manufacturing cost absorption by a further $2 million in the quarter. Within SG&A, the volume cost leverage line reflects $3 million of severance charges as we start to downsize our cost structure in response to lower volume. These were not included as part of our restructuring charges.

In terms of our integration synergies, Slide 10 details the facility closures. In the quarter we closed our small Santa Fe Springs, California facility. With the work we've already done and the projects currently underway to benefit 2009, we remain on track to deliver our synergy targets.

We have a number of surface buildings from earlier closures. Four of these are under sale contracts, with three closing during Q3 and the fourth in Q4. These will generate $25 million in cash.

Moving on to a discussion of our business segments on Slide 11, sales in Office Products decreased 9%, with underlying volumes down 12%. Previously reported share loss represented 4%, and slower end user demand and related inventory reductions represented 9%.

Sales reductions were largely in the US and UK, and partially offset by the benefits of foreign exchange, price increases and the timing of Easter. Primarily as a result of the lower volume and high raw material costs, adjusted operating income decreased 17% and margin contracted 80 basis points. We do anticipate more inflationary pressures and have a broad price increase going through in January 2009. We already raised prices for some categories in July this year and may again need another interim price adjustment in July 2009.

Now turning to Document Finishing, sales decreased 5%, with underlying volumes down 12%. Once again, sales were down in North America and Europe. Share loss represented 3.5%, with slower demand and resellers' reduced inventory adding another 9%. The factors were partially offset by the benefits of foreign exchange, price increases and the timing of Easter.

Adjusted operating income for this segment decreased 24% and margins contracted 120 basis points. The decline was primarily the result of lower sales volumes and in particular a decline this quarter in our higher margin direct channel, together with higher raw material costs.

Moving on to Computer Products, sales increased 3% and volumes declined 4%. The decline was due to substantially lower consumer demand in the iPod accessory category. Without iPod accessories, which represented about 8% of Kensington's 2007 sales, volumes increased 3%. Adjusted operating income decreased 3%, and margins declined 110 basis points, to 19.7%, due to lower sales volume.

And finally, looking at Commercial Laminating, comparable sales declined 1%, with volumes down 7%. The decline was driven by lower film sales in Europe and lower print finishing equipment sales. Adjusted operating income was a loss of $600,000, compared to income of $300,000 in the prior year. The decline was the result of lower sales volumes and higher raw material costs.

Slide 12 provides some assumptions to help with modeling future years. We have added the additional charges associated with the new productivity initiatives to cash restructuring charge figures. The new components add $10 million in 2008, $15 million in 2009 and $15 million in 2010.

We expect second half cash flow to be in the range of $100 million to $120 million, excluding any potential proceeds from the possible sale of the commercial print finishing business. This puts full-year cash flow in the range of $40 million to $60 million. Our cash flow is always seasonally weighted to the second half of the year. Based on our current forecast and the seasonally strong second half cash flow, we do not foresee any bank covenant compliance issues. We expect our ratio of gross debt to EBITDA to be in the range of 3.5 to 3 times.

That now concludes my prepared remarks.

At this point, David and I will be happy to take your questions.

(OPERATOR INSTRUCTIONS)

Your first question comes from the line of Bill Chappell, of SunTrust Robinson Humphrey.

Good morning.

Good morning, Bill.

I guess maybe kind of walk through just the business environment over the past six months in the US. I mean, have you seen a continued stepdown in terms of consumer takeaway, or has the real change been kind of international business slowing down a step further?

Sure, happy to do that, Bill. So let me kind of start with sort of an expectation at the beginning of the year. I think that we along with many others in the economy did not believe there would be the degree of consumer demand turndown as well as sort of conservatism we've seen with the sort of business spending. I think that sort of dialed up over the course of 2008. And clearly that has been led with the US market. So it's really the US. And then as we sort of went through the first half of the year we saw a dialing up of slowness, I think, in our UK business, as well.

So what we have seen to date really has been a first US-led and then following very quickly with a UK softness. And, Bill, as you know, sort of the nature of our products, the -- we tend to produce products that are consumed sort of in a business-to-business kind of relationship, that they're more sort of businessy-oriented than consumer, per se. And what we first saw was sort of the consumer slowdown, but I think sort of laterally as we proceeded through the first half we began to see the business slowdown.

And, Bill, just to add to that, during the second quarter, particularly what also accelerated was mainland Europe and Canada joining on with the UK and US market, and also within the US the direct sale channel in DFG also took a big downturn, which had stayed up through the first quarter. So our US experience actually deteriorated, even though it didn't on the indirect channel.

I think, Bill, as we chat with sort of customers and others, we, I think, see this as a pretty typical trend that we're seeing broadly for our industry.

Sure. And when you're talking about the price increases, both in the past and going forward, I mean, are you seeing pushback from the retailers, or is it more pushback from end consumers that may be trading down as the price points just get too high?

I'm sorry. I think I missed sort of part of that question.

Well, just on the price increases you're passing through, are you getting to where the price points are too high and pricing some of the consumers out of the market?

Right.

Or are you even seeing any pushback from retailers, saying, "Hey, we don't -- I mean, we can't take these price increases right now. It's slowing down our business"?

Right. Okay, so I think that what we're seeing in terms of the cost increases, the sort of oil driving plastics, freight, those kinds of expenses, they really sort of broad across the industry, yes? And that is to say that sort of these inflationary, these cost inflationary drivers in the business really affect the industry broadly. It affects us. It affects private brands. It affects competitors. There's no question. It's broad. So I think it's one of those situations where this is an effect that is treating all competitors as equal.

I do think this, I think there is no question that as prices rise consumers have an appetite, I mean, have a limit as to what they can absorb. I think one of the interesting things that we believe that we're seeing with our sort of back-to-school efforts and energy is that much more of the consumers that kind of we can see are tending to go to the mass market outlets, want to make one trip, want to get in the car, go once with the family, buy your sort of back-to-school office supplies, buy all of that.

So no question about it, I think that -- I think consumers will have a limited appetite. I can't really speak to it affecting our business, per se, at this point, but I think we have to be cautious. And I think one of the things that we said in our script was that while we've worked well, we think, with our vendors to sort of mitigate and push back and reconfigure our vendor base to not just broadly accept these increases but to try to manage them as best we can, we have put through price increases, but we have tried to be -- we've tried to be sort of balanced and proportioned in the price increases that we put through.

I just want to add a little bit to that, Bill, which is that the consumer at this stage hasn't met the real cost increases that are coming through the organization. So just as Newell has announced large January price increases, we're also working through the same issue. And part of the issue we're experiencing and part of our guidance reflects the fact that we won't be able to pass on in a real-time sense all of the cost experiences we're currently seeing. And so at the moment I think that there hasn't been a problem passing through the raw material increases we saw, which we really passed through in January and to a small extent in July. But a bigger increase will come in January of 2009.

And I'd just go back to one other comment, Bill, and that is that the way we look at our business, we see our business as much more of a business-to-business kind of product. 70% of the products we sell are typically consumed in businesses. So it's more of a business issue for us, rather than a consumer issue, per se.

Sure. And then just one last question on the commercial business. I mean, is there any thought to taking that off the table? I would imagine with the credit markets and just the overall environment it's tougher to get top dollar for that right now. Does it make sense to kind of keep moving forward and then re-look at that 12 to 18 months from now?

Actually, the position we're in with the business is that the banking arrangements we have with the business and the history of the bankers that we've got representing it in the sale process is such that they understand the cyclicality of that industry and the business, and therefore they've been prepared to offer a [staple-on] finance package with the business, which has allowed us to get attractive offers for the business. So we think that it makes sense to proceed with the sale now, and we think we're in a position to conclude that.

Great. Okay, thanks.

Your next question comes from the line of Reza Vahabzadeh, of Lehman Brothers. Please proceed.

Good morning.

Good morning, Reza.

On the cost front, do you have visibility on most of your input cost in the second half of the year to the extent that you may be hedged or have inventory already in-house, and to what extent do you have visibility, I guess?

From this point we still have about two months of nakedness in terms of our visibility horizon. And fundamentally one of the things we've seen is our suppliers take much shorter positions in terms of what they're prepared to accept in terms of forward coverage. And it's fundamentally because of the volatility in the market, both in terms of commodities and currencies. And so the traditional levels of forward purchase order coverage we may have been able to get have been reduced in the current market. And so we have a couple of months of still uncertainty.

I would also say that there is a lot of issues in the entire supply chain associated with people being able to cope with the rising cost of their own inventories. And so one of the issues we've been seeing is suppliers with cash crunches as much as with raw material price inflation.

Okay. And do you have any feel for sales trends so far in the third quarter with back-to-school also, I guess, starting any time soon?

We always have a strange position with back-to-school, because the sell-in for back-to-school tends to be fairly standard, and it's the reorders that tell us whether we have a good back-to-school or not. So we never really know whether back-to-school is up, down or sideways until we get the reorder process. And so it's really at the tail end of back-to-school that we get a good view of it. But I can tell you that most people are saying it's slow at the customer end. But that's anecdotal evidence, not our evidence.

That was just exactly what I was going to add, Reza, that I think by and large our large customers are seeing a sluggishness. And, again, that was a comment I made earlier. I think that the part of the market that we see or the part of the channel that we see sort of being more robust at back-to-school is more the mass -- sort of the mass side rather than the -- more the traditional large customers we deal with.

Right. Your guidance suggests that you are going to be comfortable with your bank covenants later on in the year, and that makes sense. But I was curious. Your bank covenants seem to be calculated on a gross fit basis. So would that suggest that you would use your cash to pay bank debt so that you can have more than adequate cushion under the bank covenant?

Yes. I mean, our belief is as we get into the second half of the year that the cash that we generate seasonally in the second half, which is always very strong, will actually go to pay down bank debt.

I see. Okay. And then as far as the pricing increase that you announced for the January '09, is that when your pricing will catch up with input cost, or is it going to be before that?

Effectively it'll catch up with what we are now experiencing as input costs. The issue, we believe, is we're seeing such unpredictability in our input costs. We don't know whether they will stay at these levels or go down or go back up, and therefore we're also adding a lot more flexibility to our pricing for 2009 so that we can have a very broad interim price review in July of 2009 up or down, depending on what happens to input costs.

Reza, this is just an area that we are monitoring very closely, I think both on the pricing side and on the buying side. And so I think it's just truly just an ongoing, continuous process of monitoring.

And is it your view that most of your competitors also have to take comparable price increases?

Oh, I think, absolutely. As a matter of fact, these are fundamental costs across the economy that are affecting all businesses in many, many, many industries. So I think this is like a rising tide that affects sort of all boats.

Got it. Thank you.

And your next question comes from the line of Derek Leckow, of Barrington Research.

Thank you. Good morning, Dave. Good morning, Neal.

Good morning, Derek.

Good morning, Derek.

I just wanted to go back to the last recession and kind of get a sense for the wide declines back then, because it's hard for me to tell. You were a part of Fortune Brands and you were also involved in a restructuring process back then. It's hard for me to tell how deep the volume declines were. And do you sense that we're at sort of an inflection point right now, or do you feel like it still has a ways to go? I wanted to get your sense for the macro picture on that.

Derek, I'm not an economist, but I've lived in this business a while, and one thing I would tell you is this is a different character recession to the last one that we saw. We are seeing an unusual combination of rapidly rising raw material costs coupled with slowing demand. And as raw material costs get pushed through into the market, there's a question of customers moving down the price point [food] chain as they respond to that and/or further impacts on their business and therefore on their employment situation.

Fundamentally, we're impacted by white collar employment, and that has started to go negative. It's been kind of running negative all year, continuing to run negative. My belief is that that will continue to get worse. And obviously therefore I don't think that we are near the end of this. We think this is going to be a prolonged situation.

Having said that, though, Derek, I just refer to what Neal said. We are not economists. And this is just a -- I think this is a difficult period for just a bunch of folks in terms of understanding, really, what's going to go on in the economy here.

Yes, I'm just trying to get a sense for the volume levels that were down in the last one, because as you guys were restructuring back then, I think this 11% volume decline in the Office Products category seems to be larger than what we had back then. I think that was 5% back then. So I'm just trying to (inaudible). So the question is, is this just -- is there some inventory rebalancing going on here that's in excess of what the normal business trends would tell you, or do you feel like there's something else going on?

Part of what I tried to call out on one of the slides is what I think the various inputs are. And if you look at Slide 8, you can see for the second quarter, and I give the same for the first quarter, the breakdown of where we're seeing the decline. And so we do have some loss placement and we have some planned exits which are part of our numbers, making it look slightly worse.

Okay.

And we try and estimate what we think the channel inventory reductions are. But fundamentally the slowdown in demand that we're seeing is more pronounced than we saw going into the last recession. And I don't exactly know why that is, but it seems to be that everybody from our customers is seeing that same reduction in demand. And so it's not unique to us. It's their level that the demand is being lost as opposed to something happening in the -- in share shifts or something like that.

Okay. And then as far as your customers' behavior is concerned, when you announce publicly that you're going to have a pretty large price increase in January, do you think that also has an impact on their inventory levels during, let's say, Q3 and Q4?

That's one of the always unknown issues. And I once said that I thought there would be a pull-forward ahead of that. I think that there could be in some customers this year end, but we're not banking on that. And if it happens it'll be an upside. And it'll be a swap between Q1 and Q4.

And then is there anything meaningful in terms of new products that you're going to be launching during the next six to 12 months?

Well, I think that's one of the things I talked about, Derek, sort of in my comments. I think that we believe that -- we've talked about there being a pretty decent rollout in new products in our Kensington business. I think we see over the back half of '08 and into '09 some new product platforms across our binding, laminating and shredding business. Also in our Document Finishing business, we've really revamped the US direct sales channel, I think, to make that more effective. So I think as we introduce these products we believe we can be more effective in taking them to our direct customers.

We've also developed a direct sales organization now. We're building a direct sales organization across Europe. And we think that that will help accelerate some of these new products in Document Finishing. And the third area I think is our workspace tools area, where sort of new products as well as new merchandising is being introduced for a lot of the desktop and electric areas that we've introduced. So, really, all of that is sort of baked into sort of Q4 2008 into Q1 of 2009.

Okay. Well, thank you for the update. Good luck.

Thank you.

And your next question comes from the line of Bill Schmitz, of Deutsche Bank.

Good morning, guys.

Good morning, Bill.

Good morning, Bill.

Hey, can we just talk about -- I know you have those charts, Neal, on sort of white collar employment trends, and I know that you guys are doing employee reduction, as well, but if I kind of look back at the entire earnings season through all the companies I cover from other industries, it seems like people are making their numbers by SG&A cost reductions. So what does that do for the demand environment? I mean, do we need to wait for an uptick in that kind of white collar employment level for you guys to get to sort of a normalized sales base?

So I think we will see two things that kind of roll into the latter half of the year. I think the inventory reductions in the channel will abate, but I think that you will see white collar employment continue to go down. And so that's why we're basically assuming that the second half is going to continue to be poorer than we would have originally anticipated. And at the end of the day, what we need to do, fundamentally, is to drive consumer interest in our product, and that's why we are keen about all the new products that we've got already coming through the pipeline which get launched in Q4 and in 2009. That fundamentally is what will help improve demand.

I also believe, Bill, that we view -- there's market softness, part of the decline. We've also talked about sort of our share loss that we view as a temporary situation. And I think we're being aggressive now about sort of going after that share loss. We are working very closely with customers and sort of going back and trying to revisit some of the share loss that occurred during the transition, particularly with the -- with what we would call Tier 2 and Tier 3 suppliers. So as we sort of review this situation, we are making sure we've got the right people involved in every bit; making some tough decisions on sort of tradeoff with price and margin; again, trying to become more aggressive in the marketplace now that we've got the infrastructure, now that we've got sort of a lot of the transition bedded down. We're really trying to get far more focused now on the market share piece that we've talked about it and go right after it.

Got you. What's the breakdown now between consumers and businesses in terms of consumption for the business as a whole?

So fundamentally business consumers are still around 70% of our demand. And out of the -- that we would call the consumer demand, a lot of that is actually small office, home office, as well.

Right. Because like who's going to buy a stapler or a whiteboard if employment's declining, right? I mean, so you can do all this great stuff on market share gains, but if the category continues to decline, I'm not sure what the end game is.

Well, if you look at some of the machinery we're launching on the DFG end, what that allows is productivity improvements for our customers. Some of those higher end machines have labor associated with using them. And so they will be very keen for people to purchase, because it actually gives them a cost reduction in their own processing and (inaudible).

Got you. Okay. And then just on the cost side, I mean, are you seeing a pullback in freight rates in China now that the economy has softened a little bit?

Sorry, would you mind repeating that, Bill?

Have you seen a decline in some of the container rates yet out of China, given the fact that that economy has softened quite a bit?

Not significant.

I think more of our efforts, Bill, to that end, if I could speak to it, is trying to make -- work on the logistics ends. So we make sure that we can order smaller quantities, mix and match what goes into a container, and just be more effective and efficient in the utilization of container space. I think we've found that to be an area of opportunity for us.

Got you. And will there ever be a point in time where you guys don't manufacture anything directly? I mean, will you ever have a 100% variable cost model?

No. No. Absolutely not. I think that it really speaks to sort of the nature of how we sort of have looked at our products. We believe, Bill, that there are some products that fundamentally have a very, very high labor content, and by the nature of their cost structure they really should be produced in a low labor -- a low cost, low direct cost environment. We believe that we have other products that by their nature have a very high freight, distribution, bulky kind of nature.

So what we have done is a very conscious division of those kinds of products, produce close to the customer, where it makes sense to make close to the customer, produce in low labor areas where direct labor is the issue. So that's been a defining issue for us. We have not kind of peanut-buttered our approach to say we're going to manufacture versus we're going to be an outsourcer. I think we've very deliberately made conscious decisions.

Okay, great. And then just one last one, if I could. Could you just, Neal, remind us what the debt covenants are and what your target is for the end of the year and what the implications are if the unforeseen happens and you do break those covenants?

Sure. So we fundamentally have two debt covenants. One of them is our gross debt to EBITDA ratio, which currently requires us to keep that at 4.25 or below. And that reduces in Q4 to 3.75. And then the other one is our interest coverage, which is currently three times multiple, and that actually doesn't change. And so the tighter covenant for us is the gross debt to EBITDA. And, you know, fundamentally, if ever you breach your debt covenants you enter a negotiation with your bank, and the most likely outcome of that is you pay a higher interest rate going forward. It's not that there's some great doomsday that results.

Right. Who is the banker (inaudible) able to discuss that?

It's a consortium, and it was put together when we spun out of Fortune. It's led by Citibank, but there's actually about 35 different banks involved. And they're not concerned. We only addressed this because we had heard that there were a number of shareholders who were concerned about the issue and that it was something that they felt we should address on the call.

Okay, great. Thanks so much.

(OPERATOR INSTRUCTIONS)

Your next question comes from the line of Arny Ursaner, of CJS Securities.

Hi, good morning.

Good morning, Arny.

Good morning, Arny.

I'd like to try to focus if I can on kind of the negotiation process you have with your key retailers going into January. It sounds like from your prepared remarks that it's virtually impossible to hedge the underlying commodities you would need to build your products. It sounds like you're asking your customer to have more flexibility in their pricing post-January, and I assume they're trying to create catalogs that have essentially fixed price. So as you go through this process where your raw material costs are a complete unknown, you need and they want some pricing flexibility in this equation, when you negotiate with these key retailers, are they negotiating on the price of the product or are you finding it's easier to perhaps show them more of an open book and negotiate on your behalf to achieve a fair margin?

Okay, that's such a good question, Arny, and I think the answer is kind of all of the above. So first of all, I think we're in a different day. I think that that's just a basic reality, that there always have been certain product categories within our business that are -- have kind of fluctuated more rapidly. And so our customers had sort of accommodated that, because they felt that there were some areas of the business that were more flexible and rapid and volatile and some more stable.

So the world has changed. I think that what's happening now is what we're seeing is that there's just sort of greater volatility on the cost side for much more of the products that are sold in our industry. And so I think as such, I think both our customers are changing their relationship with their customers and we with ours. The whole chain is sort of shifting a little bit.

I think if you take a look at sort of comments made this quarter, there are other producers of office products that have said, "Gee, we're now looking at going to a quarterly price increase." I think that we aren't quite there yet, but we certainly, in this mid-quarter year, this last quarter, put through some price increases that we just had to, we believed we had to. And I think that there was some flexibility in that.

So I think that people are looking for time. Time is a big factor. It's not necessarily just the increase. It's the timing and how much time you can give people. So we're just trying to work around all of that. I don't think that at this time we want a peanut butter approach. We don't want to just sort of rigidly say this is the time frame. We want to be looking at this area by year end, making sure that what we pass on really has to be passed on and it's done in a way that accommodates people as best as possible. Does that speak to your issue?

I think it does. As I said, you're dealing with an incredibly challenging environment. It sounds like you're doing the best you can to deal with it. Another question I have is, you in the past have been more than willing to walk away from business when you couldn't earn a reasonable return. With this changing commodity environment and pricing environment, are there more of your businesses that may be ones you believe make no sense for you to continue to do?

Well, I think that -- no, I think that we've really sort of purged a lot, really exited a lot of the commodity categories over the past two, two and a half years. And I think that was -- in hindsight, as we look back on that, we think that was the right and sensible thing to do. That's really now put us in a position where the product areas and the product categories that we're in really are the ones that we kind of more see ourselves being long term. So I don't think that we are now saying that something that we once saw was good we want to exit. Not at all. I think that we believe that what we've got here has been sort of carefully assessed.

So I think what we're really saying is that we just want to be -- get very close to our customers. Our customers will, no question, over this period be making decisions about strategic vendors, who they believe are their long-term strategic vendors, who are going to be the people that really have invested in their business? I think in my prepared comments I spoke to this. I think this is a tremendously important point.

As I look around our industry, Arny, I don't see a huge number of people really investing in fundamental infrastructure systems, product development, etc. We are. And I think that our customers see that, and our customers, I think, will realize and appreciate that, golly, if we're going to have a future, as we become bigger, as we integrate, as we -- as they go into sort of their natural evolution, I think they're going to want to align themselves with people who have invested well in their industries. So I think that's what we're trying to do.

Okay. Final question, if I can, David, I know you're a man that does very careful contingency planning, to the extent you have call it five contingency plans. Given the current environment, how far down in your list of five did you go?

Okay, Arny, I'm not going to answer that one. I think I have no idea how to answer that. I would say this, and, again, I kind of go back to my script. I think that what we are doing is aggressive, no question about it. We are really trying to bring forward and lever the good things that I think we've done with our systems and our distribution infrastructure. So the way I would look at it, it's not how far down on the contingency plan you're going, it's sort of how aggressive and how much are you trying to bring forward. So no question about it, we have some levers left, and I think we're trying to be proportioned and balanced here.

One of the things we're not doing, and I think it's important I stress this, that we're not doing radical cost-chopping kinds of activities. We're trying to accelerate into the future. And that is to say that what are the things that we want to be bringing to bear in our business? We want simpler processes. We want more consolidated activities in our ops and finance area. So we're not cutting into muscle. What we're doing is we are really trying to bring forward more rapidly the benefits that would logically accrue, but rather than in 12 months and in 18 months we're just trying to bring them forward faster.

There are no further questions.

I would now like to turn the call back over to Mr. David Campbell.

Well, thanks very much for all your good questions. I appreciate your interest in us, and we look forward to chatting again and updating you further on the progress we've made in our next call in November. Have a great morning, and thanks.

Ladies and gentlemen, that concludes the presentation. Thank you for your participation. You may now disconnect. Have an excellent week.