ODP Corp (ODP) 2008 Q2 法說會逐字稿

Good morning and welcome to the second quarter 2008 earnings conference call. (OPERATOR INSTRUCTIONS). At the request of Office Depot today's conference is being recorded. I would like to introduce Mr. Brian Turcotte, Vice President of Investor Relations, who will make a few opening comments. Mr. Turcotte, you may begin.

Before we begin, I would like to remind you that our discussion this morning may include forward-looking statements, which are subject to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements reflect the Company's current expectations concerning future events and are subject to a number of factors and uncertainties that could cause actual results to differ materially. A detailed discussion of these factors and uncertainties is contained in the Company's filings with the SEC.

I would now like to introduce Office Depot's Chairman and CEO, Steve Odland.

Good morning and thank you for joining us for Office Depot's second quarter 2008 conference call. With me today are Charlie Brown, President of International and acting CFO; Chuck Rubin, the President of North American Retail; Steve Schmidt, the President of North American Business Solutions Division; and of course Brian Turcotte from Investor Relations.

The press release and accompanying webcast slides for today's call are available on our website at www.officedepot.com. Click on Company Information and then Investor Relations.

During our first quarter earnings call in April we provided a second quarter outlook for the Company that included sluggish sales and a 200 to 250 basis point decrease in EBIT margin from the previous year's level of 4.7%.

The International and North American Business Solutions divisional performance was close to our original expectations. However, as we noted in our press release three weeks ago, Office Depot continued to be negatively impacted by the challenging economic environment in the second quarter of 2008, and we estimated that our EBIT margin could fall an additional 200 basis points.

While our actual EBIT was within that revised outlook, most of the shortfall versus the original expectations was experienced in the North American Retail Division. Sales were below expectations, particularly late in the quarter. And our product margins were also below expectations, and our fixed costs were significantly deleveraged. We experienced higher-than-expected shrink charges following our annual physical counts in the quarter.

In the corporate area we recognized severance costs from a late quarter staff reduction and legal and professional expenses related to our proxy contest and regulatory matters.

Second quarter 2008 total Company sales were $3.6 billion, a decrease of 1% compared to the second quarter results last year. The net loss on a GAAP basis was $2 million compared to earnings of $106 million in the second quarter of 2007.

The GAAP loss per share on a diluted basis was $0.01 for the quarter versus diluted earnings per share of $0.38 versus year ago. But the as adjusted diluted earnings per share for the second quarter were $0.04 versus $0.41 in the same period last year.

Total Company operating expenses as adjusted represented 26.9% of sales, an increase of 110 basis points over the second quarter of 2007. EBIT as adjusted was $21 million in the second quarter or 0.6% if expressed as a percentage of sales, compared to $170 million or 4.7% in the same period last year.

The division Presidents will walk you through their action plans to improve the performance in each of our three businesses. I would like to set the stage by telling you that the management team and associates at Office Depot will continue to do everything we can to profitably grow the top line, cut costs, reduce our CapEx and improve cash flow.

For example, to profitably grow our top line we are expanding entry-level price points for core business essentials in North American Retail, as well as rolling out tech services nationally, bundling newly expanded services with our products, and aggressively growing Worklife Rewards signups.

We're increasing our focus on direct marketing in the Business Solutions Division, particularly in the catalog area, and implementing our customer contact strategy.

In international we're focusing on our marketing strategies on retaining and expanding existing customers in the UK. And we're rolling out Tech Depot and our design, print and ship services there.

To cut costs and reduce CapEx we're reducing the number of anticipated stores to -- store openings to less than 15 stores this year, and remodels to eight for the balance of the year in North American Retail. That is less the 15 stores left for the year.

We are conducting line reviews with our vendors, and we initiated a voluntary exit incentive program for certain employees.

To improve cash flow we are working to reduce our working capital through reduction in our global inventory and our receivables level.

Now I will turn the call ever to Chuck Rubin to talk about North American Retail.

Second quarter sales in the North American Retail Division were down 6% to $1.4 billion. Comparable store sales in the 1,178 stores in the US and Canada that have been open for more than one year decreased 10% for the second quarter.

We experienced sales declines in our major product categories of furniture, supplies and technology. Sales slowed noticeably at the end of the second quarter, but comp sales trends have improved slightly thus far in July.

Similar to what we have reported over the last couple of quarters, we continue to be negatively impacted by weakening business conditions in North America. Specifically weakness in Florida and California continued to weigh heavily on our results; however, their impact to our sales has remained consistent to what we have reported over the past two quarters after worsening the previous six quarters.

Outside of those two states, we have experienced a further decline in demand as this economic slowdown has spread throughout other regions of the country. All of the decline according to a third-party econometric modeling is due to macroeconomic factors. While most of the sales decline was measured by a reduction in the number of transactions, average order value also was down slightly versus the same period one year ago.

In the second quarter we opened six new stores, closed one, and relocated three, bringing our total store count to 1,272. We also remodeled two stores, bringing the total for the first half of the year to three stores.

We are pleased with the continued progress made with our service levels. Mystery shop scores were 96% in the second quarter. That is up nearly 4% versus last year. And our in-stock service rate on our top 200 selling SKUs was over 99%.

The operating loss in the North American Retail Division was $4 million for the second quarter of 2008, a decline from record second quarter operating profit margins of 6.5% in the same period of the prior year. We're very disappointed with the operating margin results, which were driven by deleveraging from lower than expected comps and gross margins.

With lower sales levels versus year ago, fixed costs and operating expenses deleveraging reduced margins by approximately 290 basis points compared to last year.

The operating expenses impact was driven primarily by a deleveraging of payroll as we reached a base level of staffing in the second quarter, traditionally our lowest volume quarter, that is required to maintain our customers' expected service levels.

On an actual dollar basis SG&A was flat versus last year, despite additional costs related to an additional 86 stores opened since the last year.

Product margins were approximately 220 basis points of the decline. As we previously communicated, lower vendor program support was expected due to lower sales volumes discussed on previous earnings calls. However, vendor program support was also lower due to a shift in mix of product sales and the continue tightening of support from vendors.

Additionally, we conducted clearancing to mitigate inventory risk, which was partially offset by private brand and better promotional management. And finally, inventory shrink lower our margins by 170 basis points.

Let me outline the actions to improve our operating margins going forward. First, we are accelerating our product assortment reviews to reduce our overall SKU count to ensure the lowest possible cost, and thereby improve margins.

We expect to have a significant portion of these completed by the end of this year. Since June, for example, we have completed nine line reviews, resulting in significant cost savings in our future purchases, which will certainly improve our future margins.

Secondly, we are micro assorting our key technology departments to better match our offering to the individual store sales volume and customer profile. We believe that this action will lower end of quarter financing activities.

Third, we are implementing stringent inventory controls to support more conservative sales forecast, which are roughly comparable to what we have seen year to date. This should reduce end of life clearancing and improve margins and cash flow.

Fourth, we are significantly reducing our new store opening plans. While we still believe in the long-term prospects for growing our real estate footprint, we will open less than 15 new stores for the balance of this year, and a total of about 45 stores in 2009. These are committed leases which would cost more to break than to actually open the stores.

Fifth, we are slowing our remodeling efforts. For the balance of the year we anticipate remodeling eight more stores, and they will be landlord funded. Like opening new stores, we believe in our M2 format, and our goal remains to have most of our North American Retail stores in the new format at the earliest possible date. However, we need to control our expenses and capital spending during these challenging economic times, and we will be taking a more conservative approach to remodeling stores.

Six, we will continue to manage our costs. As a result, we are reducing our North American Retail headcount based on our corporate office. This reduction is through increased efficiencies and will not impact our commitment to the high service levels we have in our retail stores.

I will now address the Taking Care of Business key actions to improve our sales going forward. We will address our customers' increasing need for low prices and high-value by focusing on expanding our entry-level price points for core business essentials. Partnering with our key vendors to secure opportunistic onetime purchases that deliver exceptional value. Offering bonus packs that provide additional product to the customer for little to no additional spend.

Providing product and service bundles that offer a complete solution to the customer, while also saving them money. And continuing to focus on maximizing our high traffic promotional space by utilizing the stronger merchandise impact in selling high-value products. In addition, for bigger ticket purchases, we will offer extended financing through our banking partners.

We will also continue to aggressively target our Worklife Rewards Loyalty members. These valuable customers shop more often and spend more money with us than non-Worklife Rewards customers and have higher margins. During the second quarter we continued to grow our membership by 25% versus a year ago. For the balance of this year we will increase our targeted advertising to these members with unique offers and special pricing. And we will also continue to focus on increasing our membership base.

We will expand our portfolio of services to fulfill the unmet needs of micro business customers. To date we're very pleased with the performance of our tech services offering, and expect to roll it out to all stores nationally during the third quarter. This in-store or on-site technology service ensures technology products are properly set up and addresses the customer's needs.

In addition, our design, print and ship offering will expand our capabilities and customer solutions through vendor partnerships and infrastructure investments.

And finally, we expect to expand our other service offerings, including tech recycling, a small-business leasing options for technology furniture and services, and identity theft production to round out our service offering to the micro business customers. All of these offerings have higher than average margins.

As we look to the balance of the year, we see continued sales challenges, although our very early third quarter sales shows slight improvements. We remain committed to our customers and believe offering them great value in our product and services, along with a friendly, helpful store environment, is critical.

We believe the plans I have outlined, along with the historically higher revenue levels of the third and fourth quarters, will return the North American Retail business to profitability.

Now I would like to turn the call over to Steve Schmidt.

Total sales in North American Business Solutions Division were nearly $1.1 billion, down 5% versus the same quarter of last year. Despite low single digit sales growth with our large national account customers and in the public sector, a 10% sales decline to small to medium-sized customers resulted in a 5% decrease in contract sales.

Additionally, sales in our direct business declined 6% year-over-year. However, the performance of this business has improved and is beginning to show signs of recovery.

Business Solutions business in Florida and California, which accounted for about 30% of the division's sales in the quarter, continue to be soft among small to medium-sized customers. In the second quarter these two states were down 6%, making up nearly 40% of the division's total sales decrease versus the same period last year.

Outside of these two states we have also seem a deterioration in business conditions. Almost half of the decrease in division sales were related to Tech Depot, our technology business, which resulted in part from our purposely eliminating unprofitable accounts in this business. Unfortunately, we have not yet seen the flow through in margins due to the continued softness of the small to medium-size businesses that tend to deliver higher margins.

The North American Business Solutions Division had an operating profit of $49 million for the second quarter of 2008 compared to $78 million for the same period in the prior year. The operating margin decreased from 7% in 2007 to 4.6% in the second quarter of 2008. Our margin was about 60 basis points lower than expected due to lower sales and customer mix. The key components of the operating margin decline versus year ago include the following key factors.

Approximately 160 basis points of this decline related to product margins, including a change in customer mix, increased promotion activity, and some cost increases that could not be fully passed along to our customers. Additionally, we experienced a decrease in vendor program support, which reduced operating margin by approximately 40 basis points.

Other negative impacts to operating margin, included a deleveraging of fixed costs against lower sales levels totaled approximately 70 basis points. And offsetting these negative factors, operating expenses as a percent of sales decreased approximately 30 basis points from the second quarter of 2007.

Before I update you on our action plans in North American Business Solutions, I will review the status of our state contract business. Office Depot currently has state contracts in 21 states in the US. And in many cases we have very long-standing relationships.

The state of Georgia is one example where we have been long -- we have had a long business relationship for over the past 20 years. A great deal has been written about this issue, so let me clarify a few points.

Since 1998 Office Depot has successfully served hundreds of state and local customers in Georgia, selling millions of products to satisfied customers. In 2006 the state of Georgia decided to go to a single source statewide contract. Office Depot won the competitive bid for the statewide contract, which commenced in March of '07.

While we believe that our performance under the contract was very good, the state elected to terminate our contract for convenience, a decision which we strongly disagreed based on our performance. Office Depot is not suspended or otherwise precluded from selling to customers in Georgia.

Although Office Depot is not participating in the current bid, we will continue to offer superior products and services to any state and local agency until a new contract is awarded, and thereafter to numerous local agencies that are not required to use the statewide contract. However, we do have annual sales impact of approximately $20 million.

Turning to our Taking Care of Business action plan, first we have completed the pilot test of our behavior-based customer contact strategy, and have rolled out the tools and processes of this plan to the entire BSD field organization. To date we're very encouraged with results and expect it to have a positive impact on our performance in the third quarter of this year.

Second, although our outbound selling telephone account management, or TAM organization continues to improve, it is still not meeting our expectations. We will continue to work very closely with the two third-party firms who handle this business, by instituting key performance indicators, new hiring standards and marketing programs, as well as improved call processes.

As I mentioned last quarter, a third-party firm hired some of our best former sales representatives, and preliminary results remain encouraging, with their revenue performance outpacing the results of our other TAM representatives. We feel that all of these changes will significantly upgrade the entire TAM organization.

Third, our direct marketing team has made considerable progress during the quarter. We significantly increased our focus on this area, particularly in catalogs, and the results are beginning to pay off. Additionally, our customer file, which is a measure of our unique customers who have purchased from us in the past year, grew for the first time since 2005 in the second quarter.

Fourth, we are currently executing our website optimization plan, which will include customer-focused enhancements, like suggestive selling and advanced search techniques.

Our Internet sales on a global basis continued to grow in 2008, with sales for the previous 12 months totaling $5 billion compared to $4.7 billion for the same period a year ago. In the second quarter 81% of total BSD sales were online, up from 79% in the same period a year ago.

Overall, we believe we have slowed the rate of loss of marketshare amongst small to medium-sized business customers and gained share in the public sector in large national accounts.

While our performance may not demonstrate the improvements we made in the business, we have made significant strides in our execution of the action plans and initiatives that we have laid out. For example, our supply chain and customer service scores have both improved versus year ago.

Our goal is to regenerate growth in this business, while simultaneously focusing on margin recovery. As we look to the third quarter contract sales continue to struggle. While direct is not positive, we are encouraged as it is the best trend we have had since 2005.

Let me now turn it over to Charlie Brown.

At $1.1 billion, the International Division reported a sales increase of 13% for the quarter compared to the same period a year ago. In local currency this equates to a 2% increase, driven by growth in the contract channel of 6%. The direct channel will remain relatively flat.

Business softness in the UK and a weakening of the macroeconomic environment across Continental Europe constrained our sales through the second quarter. In the UK the economic environment continues to be challenging, with many economists reporting an increased chance of the economy falling into a recession.

Similar to what has taken place in the US, small-business customers in the UK have been negatively impacted by rising fuel costs, higher food and housing cost and limited access to capital.

Outside the UK our European business has also begun to show signs of weakening, with approximately one-third of the countries reporting year-over-year revenue decreases in local currency, and the remaining two-thirds reporting low to mid single digit increases.

Divisional operating profit was $51 million in the second quarter compared to $42 million in the prior year. Operating margin was 4.6%, up from 4.3% last year, and about what we expected. The components of the operating margin increase versus a year ago included lower employee-related costs of 120 basis points favorable due to the curtailment of a UK pension fund, and investments in regional offices, warehouse consolidation, European centralization, and acquisition-related expenses and other favorable items that net to about 90 basis points.

It is important to note that while the business environment remains challenging, we continue to press ahead with or action plan. I would now like to update you on the progress we have made thus far.

First in the UK. Our customer service and call center performance are on track. The metric for on time to complete performance now ranks among the best in the industry. We now see our operations and service levels as a competitive advantage that we can leverage to compete for share in this challenging environment.

We have focused our marketing strategies on retaining and expanding existing customers. And our efforts within this area are beginning to bear fruit. We're also adding design, print and ship services to the UK to drive profitable sales growth.

Secondly, we are expanding Tech Depot into the UK, France and Germany from its initial start in the Netherlands.

Third, the International Division is exploring opportunities to use tech services, a service that has met with success in North American Retail.

Fourth, we are fully transitioning all back office transactional service functions from the UK, France and Germany to our shared service center in Eastern Europe.

We have incorporated the lessons learned from each of these efforts, and as a result our execution has improved with each subsequent transition. We continue to expect to have the balance of Europe transitioned by the end of this year. Short-term there are duplicate costs, but long-term there are substantial savings.

And fourth, we continue to leverage our global sourcing office to increase direct import and drive private brand penetration in Europe and Asia. For example, the launch of our Foray writing instruments in Europe was a success, as the productline was well received by our customers, and private brand penetration rates have improved.

Our central distribution center in Belgium has now been operational for six months, with new assortments continuing to be centralized.

I would like to take a moment -- I would also like to mention that during July we acquired a controlling interest in our long-time marketing partner, AGE Kontor & Data AB, a contract and retail office supply company operating in Sweden. This stake, which was purchased through a competitive auction, allows us to ensure continued service to our Pan European and global customers with operations in Sweden.

We have also received an unsolicited nonbinding proposal from our partner in our Mexican joint venture in which our joint venture partner proposes to acquire the capital stock in the joint venture owned by the Company for approximately $430 million. We have not engaged in substantial discussions with our joint venture partner regarding this nonbinding proposal. And there could be no assurance that any agreement on financial or other terms satisfactory will result from such proposal or that any transaction will be approved or completed.

Finally, as we look forward to the third quarter we see modest sales growth in local currency, reflecting a continuation of the current trends across most markets.

That concludes my remarks on the International business. I will now review our total Company's financial results.

During the second quarter we recognized approximately $16 million of charges, as part of the plan we announced back in 2005, bringing the total charges from inception in the third quarter of 2005 to $412 million.

This quarter's charges primarily were for severance and some accelerated depreciation to consolidate the European supply chain facilities. We anticipate charges of $20 million for the balance of 2008 and $40 million in 2009, for a total program total of $472 million. Our future charges may change as plans are implemented.

Also during the second quarter of 2008, the Company initiated a voluntary exit incentive program for certain domestic employees that resulted in a charge of approximately $7 million for severance expenses in the period.

Additionally, Company received a non-cash gain of approximately $13 million related to the curtailment of a defined benefit pension plan in the UK. And approximately $16 million for a charge in the US for inventory shrink. We project that the changes in our cost structure should benefit pretax earnings by approximately $8 million to $9 million on an annualized basis.

Now turning to cash flow. During the first half of 2008 cash provided by operating activities totaled $138 million compared to $293 million during the same period last year. This decrease primarily reflects a reduction in net earnings.

Depreciation and amortization decreased by approximately $10 million year-over-year as we recognized less accelerated depreciation and charges in the first half of 2008.

Working capital increased by $239 million as compared to the second quarter of the prior year. The majority of the increase is related to the timing of payments, changes in foreign exchange rates, and duplicate inventories from warehouse consolidations in Europe. We're not happy with this increase in working capital. We worked hard for many years to improve it, and we are determined to reduce it once again.

I would also like to take a moment to respond to the questions we have received in regard to two issues, our capital spending and our revolving credit facility.

First, we continue to be careful with our capital spending. And we will make adjustments as necessary in regard to new store openings, store remodels, IT, and supply chain spending for the balance of this year. As Chuck mentioned, we have reduced the number of anticipated store openings to less than 15 stores that had been long committed, and remodels to eight for the balance of the year in North American Retail.

Our 2008 CapEx is anticipated to be about $375 million, slightly more than 2% of 2007 annual sales and about 130% of depreciation and amortization. About 25% of CapEx is due to store openings and remodels, and approximately 40% is due to IT and supply chain.

Second, as you know we negotiated a financial covenant under our $1 billion revolving credit facility in the first quarter of 2008 based on the outlook for business conditions at that time. That amendment was filed as an 8-K on March 10.

The key financial covenant is the fixed charge coverage ratio. And as of the second quarter of 2008 the Company has maintained a fixed charge coverage ratio within the required range, and ended the second quarter was over 50% of the revolver capacity available.

Also, based on current projected operating results, the Company anticipates remaining in compliance with all the covenants. However, given the uncertain environment, we feel it is prudent to revise our financing plan and had begun the process to put in place an asset-backed loan facility to ensure appropriate liquidity for our business.

As of yesterday we have secured a fully underwritten asset-backed facility with capacity in excess of $1 billion that we expect to have in place before the end of the third quarter.

Now on the balance sheet. We ended the second quarter with $157 million in cash and short-term investments. Our investment in inventory totaled $1.6 billion globally, up 4% from the same last year. This increase was driven primarily by the impact of foreign exchange rates and duplicate inventories for warehouse consolidations in Europe. Excluding the impact of foreign exchange, total Company inventory was up less than 1% versus year ago. Total North American inventory levels were slightly down versus a year ago.

In North American Retail inventory per store was $909,000, down 6% year-over-year. On an average basis inventory per store was $927,000 for the second quarter of 2008, reflecting a reduction of 9% from the same period a year ago. These changes were the result of improved inventory management, as well as mitigation of inventory risk through clearancing activities.

Our net debt at the end of the second quarter was $756 million.

With that, I will turn it back to Steve Odland.

Clearly we're disappointed with the results this quarter. The results do not mirror the amount of effort that our team made this quarter, nor do they reflect the enormous progress we've made in execution and continuing to strengthen our management team.

We continue to take deliberate actions to improve our management team and add to it. Over the past 12 months we have hired a President of our BSD division. We have built a new management team in the direct business. We have restructured merchandising with a new EVP and three new Vice Presidents. We have increased the leadership capabilities in supply chain, with the addition of an EVP of Supply Chain and a new Vice President of Inventory.

All of these organizational changes are intended to return our business to profitable growth. And we are pleased with the contributions that these new leaders are making to our organization.

Although this past second quarter is typically the lowest sales quarter of the year due to seasonality, our sales were worse than expected, especially in North American Retail. And we hit our fixed costs levels very quickly and delevered fixed expenses.

We also had items that lowered our gross margin during the quarter. We do not believe that we have received any measurable benefit from the economic stimulus checks. And believe we actually may have been hurt as customers spent them and the balance of the basket elsewhere.

However, we are encouraged that the third and the fourth quarters have historically been a larger percentage of our annual sales revenue. If you look at North American Retail, quarter three and quarter four have averaged 25% to 26% of the total annual volume over the past three years versus 22% of the annual volume in the second quarter. If these proportions hold true this year, we should be able to expand margins sequentially due to volume leverage alone over our fixed costs in this business for the balance of the year.

Before we open up the call to questions, I would like to make it clear that we are committed to improving the performance of Office Depot and will continue to do everything we can do profitably grow the top line, cut costs, reduce our capital spending, and improve cash flow.

I would now like to open up the call for questions.

(OPERATOR INSTRUCTIONS). Matthew Fassler.

Two questions. First of all, the Mexican business, it looks like from your K that business -- I think in it's entirety, if I understand the disclosure, generated between $60 million and $70 million of net income. I guess you own half of that.

I guess what I'm trying to do is to reconcile that number with the number that you -- the equity income number that you disclosed on your P&L. That presumably includes Mexico and a whole bunch of other things as such that if you were to sell it what the income hit would be to offset the cash proceeds?

This is Charlie. The income number that you suggested is directionally correct. It maybe a little bit higher in terms of what they will generate this year in terms of net income. And we do count on the equity basis for that, and it is 50%.

In terms of its contribution to EPS, it is going to be in the range of about -- the contribution is about $40 million pretax, I think, would be our share of it.

Do you bring those earnings in pretax and then tax them on your own P&L, or do you bring them in above the pretax line but then not charge income tax on them?

No, no. They are tax affected. They show up in other income.

They show up in other income. But you are saying basically $40 million in net income to Office Depot. So that would be kind of a 10 multiple more or less on investment in that business.

Again, what we have -- I would stress the very preliminary nature of this. This is a number -- we shared the number with you. That number there has been absolutely no discussion around what the appropriate number should be. That was their indicative offer.

My second question is just trying to understand the international sales trends a bit better. It looked from your disclosure like the organic sales trends, rather the ex currency sales trends, actually improved from Q1 to Q2. If you can comment on the difference in the Q1 number versus the Q2 number, what the moving pieces were there? Because your commentary was not as constructive as that number seemed to imply.

I think the second quarter we did experience growth. We are seeing most of our growth in the contract channel. Which as you know, since you followed us for a long time, that the old Guilbert business forms a basis for that business. And we have been successful in turning that from a decline into a growth story. That is where most of it is.

Our sales did soften late in the quarter, just as they did here in North America. So we were stronger in April and May than we were in June.

But were you not down ex currency international in Q1 and up in Q2?

Yes. We were up.

I think you are right. We may be downplaying it a little bit. You are factually correct. We were up in local currency in international this quarter. We were down last quarter. I think what we're trying to do is temperate it because we are worried about weakening economies there, as well as the business mix, as Charlie said, because of the contract growth there.

Was there any acquisitions? The Sweden thing I guess came too late to impact the quarter, kind of a clean organic number.

Finally, just on the tax rate, it looked like to get to your adjusted number you need to do something in the mid to high teens. I understand that in a very low income quarter that could look a bit funky. Where should we be thinking for the rest of the year?

I think for the rest of the year we should be thinking probably in the high 20% range, 28%, 29%.

Kate McShane.

I was wondering what your outlook or opinion was on reducing, or potentially closing down stores. I know you announced today that you are reducing the number of stores you're opening, but what is your view on shutting down any underperforming stores?

We will perform our regular FAS process in the fourth quarter. That is our annual time -- third quarter, sorry -- that is our annual timing here going forward. We have looked at closing stores. And we have closed a few each quarter, and we will continue to do that over time as we reposition them and so forth.

But you don't plan to get more aggressive?

Yes, we have -- to Steve's point, we continue to look at our stores. We have closed about 100 stores ever the past three, four years that have been underperformers. And it is just an ongoing practice for us, so we will continue to practice that.

At this point in time we don't have plans or estimates for any significant numbers of closures.

One other question. Can you talk about your promotional stance going into back-to-school? And how should we be thinking about markdowns year-over-year?

It is a promotional timeframe. We have altered our promotional strategy to maximize the profitable sales that we have. There are some very aggressive prices out there. We have scaled back what we have done compared to previous years.

We continue to see customers cherry picking quite a bit in the sense that they are coming in and they are buying the very low margin items and not picking up the basket to the level that we have seen in the past. That is my greater concern.

I think that -- our point of view, we have watched -- trying to drive our customer traffic. We have been able to drive traffic, but they don't come in to build baskets. We're very cognizant of that. So our view is as that we've got to be careful about our price promotion. And we intend to be conservative on our price promotion. We don't intend to give away product and give away margin. We know we've got to build these margins, and we want to do that through this period of time.

I think that the primary focus will be in our Worklife Rewards area. We're very pleased with the build on our Worklife Rewards members. Those members tend to be more profitable. The margins tend to be higher. And so our focus for the balance of the year, and especially during back-to-school, will be to deepen our relationship with those Worklife Rewards members in order to build their share of -- our share of wallet with them, and build our market share with a more loyal group.

Chris Horvers.

Can you talk a little bit about first in Mexico your decision process, how you would think about what kind of scale and economy that business gives you in operating that joint venture versus divesting that and taking cash onto your balance sheet?

And then secondly, does the continued struggles in the office superstore environment and the change with Staples and Corporate Express make you think any differently about strategic options out there?

This is Charlie. I will take Mexico. First of all, I would point out that we have been in Mexico for about 12 or 13 years with this partner. And it is a business -- it is a very, very good business. Which is why our partner has come forward with this unsolicited offer.

It is the market leader in Mexico. By the way, it operates in Mexico and in the balance of Central America as well. I would stress again the preliminary nature of our discussions. This letter from our partner was unsolicited and it came in last week. We felt an obligation to share it with you.

If we can't negotiate the right terms, in terms of increasing our shareholder value, and using that cash effectively, then there's no guarantee that we will do the transaction. And we have not yet started discussions. We will start discussions in a couple of weeks.

I think our point of view is that we are open-minded to the outcome of their approach. If this happens, if we're able to proceed with some sort of transaction, this is a meaningful sum of money and it could create a shareholder value creating event.

Our current banking facility prohibits share repurchases, as you know, but we have announced today that we have a new asset-backed facility agreed to, and it may allow some. So we will study the possibilities coming out of the proposal on the Mexican JV. And again we are open-minded to it.

As it relates to other consolidation, we believe and we have been consistent right along that consolidation needs to happen. We are open to possibilities there. We need to assure it is right -- any move would be right for our shareholders, and have the right amount of risk balance in there.

The Whole Foods discussion in the case that was announced yesterday needs study by everyone. There is uncertainty in the regulatory environment. But this is clearly a highly fragmented industry, and we believe that consolidation would be good for customers, good for shareholders, and we hope it happens over time.

Does your current debt levels and/or covenants in the new facility preclude any kind of large debt finance transaction?

We haven't finished all of the new debt facility covenants and everything at this point. But clearly the current revolver that we have in place was very restricted. Our intent and our hope is that the new asset-backed facility will allow more flexibility for us.

Mike Baker.

Two questions. One is on the shrink, I don't remember that being called out before as as big of a margin decline. Can you just give us a little bit more details on what happened there and how you mitigate that?

Then second questions is, Steve, you said that margins could conceivably get better sequentially in the third quarter. As you start to come up against the big declines in 3Q last year, and then particularly 4Q last year, any thought of margins potentially improving year-over-year rather than just sequentially? Thanks.

That is a good question. We do annual physical inventory throughout the entire system, including stores, cross stocks and distribution centers. That annual process was completed in the second quarter. And then we do a true up. In this second quarter we completed that and there was a difference between book and actual inventory, and we took $17 million in a shrink charge to cover the difference.

If you think about the second quarter operating performance, my opinion is that the underlying performance is better than the results show, because you've got that $17 million hit that was not related to the operating of the second quarter. You've got the severance hit of about $7 million. And then legal costs and so forth. So there are positives and negatives in every quarter every year and so forth, but this is an unexpected amount. So that is my point of view on it.

Let me just add a little more color as well. We did have an adjustment last year as well. But we took it in the third quarter rather than the second quarter. And the actual shrink number was pretty comparable. The increase, and the reason it got called out, was really related more to some process issues we had around direct import, which those have now been fixed going forward. But it was in the quarter it was a meaningful number, which is why we called it out.

As it relates to margins what we're trying -- it is an uncertain environment as we all know. But if you look at just the North American Retail business, which is where the softness was beyond our expectations, and not -- there are differences in every business, but the North American BSD division and International performed roughly about where we expected it to. It was North American Retail that softened.

But if you look at that business, it is a very seasonal business. What happens historically, just look over the last three years the sales by quarter, that is out there, those are actual. And I think that you will see that the mix of business by quarter throughout the year is a high first quarter. Second quarter is generally about 22% of the total business. The third and fourth quarters account for 25% to 26% of the business.

What happened in the second quarter in the North American Retail business is that we hit the sort of the fixed level of expenses in labor and occupancy costs and so forth. So my point of view is that as we go forward here, if the third and fourth quarters are the same percentage of sales as they have been historically, we ought to get leverage going forward simply on that.

We are hopeful also that as we lap the third and the fourth quarters of last year, that the comparisons become easier, but we want to be cautious in how we approach that.

In effect if you comp negatively but less negatively, so to get to those percentages you just discussed then you should actually leverage your SG&A. You don't even need a positive comp, just less negative?

Yes, essentially that's correct.

Colin McGranahan.

I want to start with an easy one. Just the pension impact in the International Division. It wasn't clear to me if that was kind of a onetime gain recorded in there, or if you eliminated that pension program and until you anniversary it will have lower operating costs?

This is Charlie. The amount recorded in the second quarter was a onetime gain on the curtailment of the plan. Essentially we had -- this was a defined benefit plan that came with the Guilbert acquisition. We curtailed that plan, and of course moved the people over to a defined contribution plan as a replacement. So this is a onetime event.

However -- in terms of the size of this -- however, we will enjoy lower pension costs going forward than what we were paying in the past because it is a defined contribution plan.

That's helpful. Then the second question for Steve, just to focus on the capital allocation and cash usage, in the context of working capital performance that has continued to be not very good, cash burn year-to-date and bumping up against some credit constraints. And I know you have a credit facility that maybe can help you with that, but certainly you are bumping up against some credit limits.

It looks like in the second quarter you spent $85 million in acquisitions, of which $78 million of that was new stuff for a JV in India and buying in China and Israel. Post second quarter it looks like you're doing something else in a JV in Sweden. And then we hear today that for fiscal '09 there is going to be another 45 new stores. And I understand these are committed leases, but I would think in the current environment you would have some opportunities.

I'm trying to understand why spending that kind of cash on longer-term growth in this kind of environment with your kind of financial performances is at all a good idea.

There have been some expenses on put that were part of previous deals going back, first of all, to Israel, which was a deal going back to the mid-90s. Which part of the structure of that deal were our JV partners had the ability to put their shares to us. The same thing in our China joint venture. So there were expenditures for puts that were contractually obligated in prior years.

We did complete, and we announced at the end of the first quarter, a joint venture with the Reliance Group, which is the largest private or public company in India, one of the most successful in India. To get a toehold going in India for that it is a relatively modest amount of money to access a market of over a billion people in one of the most dynamic economies in the world.

The Swedish thing is a relatively modest amount of money. Where they decided to sell. They are our marketing partner. They do service our customers, our global customers, which are Pan European customers. And if we lost that ability to access and to service those customers there we would jeopardize potentially a significant amount of sales throughout Europe elsewhere. And so we felt we needed to take the stake here.

We took a 51% stake rather than buying the whole thing in order to conserve cash, but to preserve our ability to take care of customers.

It is a delicate balancing act, but we're trying to do is conserve as much cash as possible on one hand, while not damaging the future of the Company on the other hand. And it is delicate because these are judgment calls.

Going forward we have moderated our store openings. We're down to about 15 stores for the balance of the year, which are all committed leases. And we have said approximately 45 stores for next year. We're working to lower that. But as you know, the pipeline in real estate is 24 to 36 months.

These are leases which have been pushed out from -- they were leases that were pushed from last year into this year, this year into next year. And we'll get out of every lease that we think again economically get out of, and we're negotiating on that. But what we're saying is that we've got about 45 commitments form 2009.

So we're taking every effort we can to conserve cash. The issue on the working capital is largely an aging of our inventory. It is good inventory, but at the same time, as sales have slowed we have out run the credit terms on those. And so you have seen our AP to inventory come down, and that is a result of that inventory aging.

It is not fashion oriented or perishable, but at the same time it is aged on the credit terms. So we're mindful of all of this. We're not happy with it, and we're doing everything we can to work this inventory through.

I think we did a great job of reducing our inventory on a per store basis this quarter. I think we were down 9% on an average basis over the course of the quarter in North American Retail, despite the softness in sales to where you can see that that demonstrates focus on this area.

Charlie, I don't know if you have any other thoughts.

The only thing I would add, on the acquisitions, the bulk of the number that you referenced was the result of puts in Israel and China. We would have preferred not to have bought that Quebec incremental piece of business at this point in time. But clearly we were contractually bound from this from earlier years.

And in terms of Sweden, had we not acquired this controlling interest in our partner, we would have been closed out of Scandinavia forever.

That's helpful. So with the exception of India, a lot of this stuff was simply unavoidable.

The other thing I would add is in the receivables and inventory area, one of the largest impacts was actually foreign exchange, because we hold most of those inventories in euros.

I understand. Then just a final quick one. Steve, just in terms of the 2Q margin miss, I understand sales came in somewhat below expectations, but it seems like the magnitude of that was very large. Was the swing in North American Retail more a surprise on shrink? Because the comp at negative 10 was not materially different than the comps at negative 9 in last quarter.

The quarter's performance was consistent with what we said and what we told you we expected last quarter, with the exception of softer North American Retail comps. We did not expect it to be down 10%. That deleveraged fixed costs, because we hit the lowest percentage sales of the year. We told you we were worried about that, of course, but it was lower than expected.

Then we had unexpected items in the quarter including the shrink charge of $17 million, severance charge of $7 million, and then legal costs and so forth as we pointed out that were significant. I believe that our underlying performance is actually better than the results show.

Then as we go forward, if you just look at the percentage of sales, as I mentioned earlier on a previous question, we should be able to better leverage our fixed expenses.

This second quarter is always the toughest quarter of the year from a margin standpoint. We white knuckle it every year, but this year especially we did everything we can to take the costs out.

I think the fundamental issue here is that our customers are small businesses and our customers are hurting. They're cutting back on their expenses, including office supplies, office furniture, computers. They are doing everything they can to cut costs. Your business is doing everything it can to cut costs.

Our strategy is to alter our offering to be more value oriented, to sign up these Worklife Rewards customers to deepen that share of wallet and marketshare. Cutting our spending, cutting our CapEx, and we're ensuring our liquidity. We're doing all of those things, which we believe are the right things to do in this environment.

Dan Binder.

A few questions. First, I was wondering if you could give us a rough idea of what the cost of the new credit facility will look like versus the cost of credit on the old facility? And if there are any other more or less onerous terms tied to that new facility?

My second question was tied to vendor rebates. Just wondering with the significant decline in retail sales and obvious decline in delivery, are we close to breaking new thresholds on vendor rebates rates such that we will have a potential issue later this year?

This is Charlie. I will take the credit facility question. The revolver that is currently in place has a number of restrictive covenants, because it is obviously an unsecured facility. That facility was put in place at the peak of good times, if you will. So we're paying about LIBOR plus 65 basis points on the drawn facility.

Obviously, we are in a different situation now, and banks are scrambling. Banks themselves are having a pretty difficult time. So we thought it prudent to put this facility in place. What we're looking at is LIBOR -- on the new facility -- LIBOR plus about 200 to 225 on the drawn facility. So it is more expensive, but the covenants are substantially less because it is a secured facility.

On the -- I'm sorry.

I was just going to say that when you say the covenants are substantially less, can you just give us an idea of what the fixed cost ratio -- coverage ratio will look like?

For example, on our current revolver the fixed charge cover ratio is 1.7 times. On the new facility the fixed charge coverage ratio is about one 1 to 1. But that ratio doesn't even spring until you are at something like 85% drawn.

So you can see that you are not fighting against these type of covenants on a quarter to quarter basis. And that is why we think it is more prudent to move to an asset-backed facility.

Chuck, on the vendor rebates.

Yes, on the vendor rebates we have said before that we think on an annual basis that the rebates as a percentage of our sales is going to be consistent with what it was in 2007. We still view it that way.

The market has toughened up, but vendors are also -- we're working very closely with them. We have eliminated virtually all of our tiers that caused some problems last year. Again, we anticipate on a percentage of sales that it is going to be consistent on an annual basis.

But the challenge here is that essentially that it is geared to purchases.

It is geared to purchases, and we have been tightly managing those purchases. And we commented in our prepared comments that we are aggressively going through line reviews. And we are making -- we're having some good progress on that. Overall it is, as I said a minute ago, we think it will be flat on a percentage of sales basis to last year.

Just as a follow-up, there has been some press about this US Communities contract. I was wondering if you could address what is going on with that, and whether or not there is real risks with it?

Then lastly, with the early retirement package, I know it may be hard to gauge it, can you give us an idea of what kind of talent may have been lost in that process, and what was ultimately really achieved by doing that and why you did it?

This is Steve Schmidt. Let me take the US Communities question. First of all, our relationship with US Communities is as strong as it has ever been. US Communities actually just completed an audit of four major markets, and our performance was absolutely stellar. In fact, a press release was actually put out that talked about the results of that audit. And we continue to have a great relationship with US Communities and we will continue to develop that relationship going forward.

Then on the voluntary exit plan, it wasn't actually an early retirement plan, it was a voluntary exit plan that was conducted here at our corporate headquarters. There are about 130 people, largely administrative people. But people really spread throughout the organization that helped us lower our cost and adjust our G&A to our sales level.

And while we will miss many of them, I think that we are just fine in terms of the talent we need to run the Company for the long term.

We have time for one more question.

Gary Balter.

It is actually Seth and Gary. A quick question on the shrink. You mentioned that your annual physical inventory count led to a shrink charge this quarter. You took one as well last year in Q3. I think you also took a pretty significant charge in Q4. Can you just tell us -- differentiate for us what these charges are and how I should think about shrink going forward?

This is Charlie. Yes, we did take -- I guess the color I would add is we took about a $17 million charge in the second quarter. Last year in the third quarter it was around about $6 million. The delta, that $10 million, was really related to direct imports. And some process -- as you know, here we're bringing goods directly in from China ourselves. We had some process issues that we needed to shore up, which we have now taken care of.

As we look at shrink going forward, we think the process issues that led to this unusually high number of $17 million in the quarter have been dealt with. So we think it will return to more normal levels going forward.

The actual shrink levels that is governed by theft in the stores and loss of inventories due to exposure to customers, is one of the lowest in all of retail. We are running closer to 1%. So the issues here were related to shortages from shipments that caught in the true up. And we put the processes in place to plug that going forward.

The other think I would add, is we report a shrink reserve every month as a percent of sales. That is the way most retailers do it. To some extent the $6 million that we recorded in the second quarter is reflective of the fact that our sales were lowered, so therefore the amount of accrual was actually short. It was really the direct import piece that was the main driver of the $17 million.

Understood. Thank you. Then just secondly on vendor support, you mentioned tightening your vendor support -- understandable in the environment. Does that also include tightening your terms in terms of days to pay?

No, I don't think it includes the payment terms. I don't see those being reduced. We're working in fact hard on extending them.

Just following up on that, the new facility, this is the first time you are going to have the inventory tied in with the bank. Will that change -- like vendors obviously now no longer have a direct access to that inventory. What have you heard from vendors, or are vendors not aware of the new structure?

This is Charlie. The new facility will have the inventory and receivables pledged as collateral. But in essence the facility will work the same as it did before. It will be a drawn facility. It is just in case we default, which obviously we don't see as a possibility.

Right, but previously it would have all been in one pool and now the receivables and inventory goes to the vendor -- it goes through the bank first, right?

If we were to default and go into liquidation and bankruptcy, then of course, yes, it would go. The banks would have a first call on that.

But that is so far from the realm of what we're talking about. We're only half drawn on the current facility.

Actually we have more than half of the current facility undrawn at present. So the issue here candidly was really around the covenants. It wasn't on the drawn. It is chasing this fixed coverage charge ratio quarter to quarter, we didn't think -- and given the tightening credit markets -- was the right thing for us. And so because the covenants are substantially reduced on an asset-backed facility because you have the asset backing, it gives us release in the covenant area.

I think our shareholders should feel really good about --.

It is actually a good thing.

Because there is -- given what is happening in the liquidity market, this assures access to capital. And we think a lot of firms are going to be moving to this market. We are early in this process. We're not at the covenant level. We don't project to be at the covenant level. And we're less than half drawn.

But we think it is a prudent thing to guarantee that we've got liquidity for the long run. And it is a little more expensive, but that is a small price to pay for the insurance policy of having access to liquidity and making sure that we can run this business for the long term.

Appreciate it. Just one other thing to follow up on. There was a comment made about Georgia. We read all this trade press obviously. And some of it is very negative and obviously somewhat biased in certain regards. Can you discuss why the contract was terminated? Also expand that to what is happening in California and Florida, just to clarify all that.

This is Steve. First of all with respect to the publicity that has come out on the subject, really much of what has been said is really incomplete, it is inaccurate, and recites all types of facts that are completely out of context.

We're not infallible, but at the same time we're absolutely committed to contract compliance. We have been doing this. And so when the facts come to light in almost every single case, we basically have taken what has been said, disproved it, and have validated our position.

In the state case of the state of Georgia, we again -- what we talked about was we were awarded a single source, single provider contract in March of '07. [We have been] -- and the contract was canceled. We challenged that. And basically came to an agreement with the state of Georgia, which first of all, we always have been doing business in the state of Georgia. We continue to do business in the state of Georgia.

And basically after discussing the facts came to an agreement to continue to do business in the state. And that basically, as all of our contracts have, any customer has the right to cancel the contract basically with proper notice. So we were able to do that.

Then regarding other state contracts, the audit process is something that goes on as part of normal business. And we're cooperating with the state of California, as we are with other states, where these audits go on. We feel confident that the results will be favorable once completed.

I think we have run over our time. I would like to thank everybody for joining us today, and once again make clear that we are absolutely committed to improving the performance of the Company. And we will do everything we can do profitably grow the top line, cut our costs, reduce our capital spending, and improve our cash flow to add shareholder value over the long term.

Thanks for joining us today.

Thank you. That does conclude today's conference. You may disconnect at this time.