ODP Corp (ODP) 2018 Q2 法說會逐字稿

Good morning, and welcome to the Office Depot Second Quarter 2018 Earnings Conference Call. (Operator Instructions) At the request of Office Depot, today's call is being recorded.

I would like to introduce Richard Leland, Vice President, Finance and Treasurer. Mr. Leland, you may now begin.

Good morning, and thank you for joining us. This is Rich Leland, and I'm here with Gerry Smith, our CEO; and Joe Lower, our Executive Vice President and CFO. I also want to introduce you to Tim Perrott, who joined Office Depot last week and will be leading our investor relations activities going forward as we become even more proactive in our investor outreach and allowing me to focus on other responsibilities.

On today's call, Gerry will provide an update on the business, including highlights of some noteworthy achievements during the quarter and progress towards our transformation. Joe will then review the company's quarterly financial results, including our divisional performance. Following Joe's discussion, Gerry will then have some closing comments, and we'll open up the line for your questions.

Before we begin, I need to inform you that certain comments made on this call 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 U.S. Securities and Exchange Commission.

During the call, we'll use some non-GAAP financial measures as we describe business performance. The SEC filings as well as the earnings press release, presentation slides that accompany today's comments and reconciliations of the non-GAAP financial measures to the most directly comparable GAAP financial measures, are all available on our website at investor.officedepot.com. Today's call and slide presentation is being simulcast on our website and will be archived there for at least 1 year.

I'll now turn the call over to Office Depot's CEO, Gerry Smith.

Thank you, Rich, and good morning to everyone on the phone with us today. I'm very pleased to be here with you this morning, and once again, report on the positive momentum we are seeing in the business. The actions we have taken to drive demand have continued to gain traction and drove improving performance in the quarter. As you know, one of the key pillars of our strategy is to strengthen our core operations, and we've made significant progress in this area. We are seeing tangible evidence across the business that our initiatives to drive demand and grow the customer base are working. At the same time, we're also gaining traction in our transformation efforts to fundamentally reposition Office Depot as a provider of both products and services that leverage our omnichannel business platform.

Beginning on Slide 4, I'd like to share with you some of our strong second quarter financial highlights. Total sales in the second quarter were $2.6 billion, up 11% versus the prior year. Say that again, up 11% versus the prior year. This is an acceleration from the 6% growth rate that we drove in the first quarter of the year. While the acquisition of CompuCom clearly played a major role in the overall growth rate, I'm extremely pleased that we're able to drive sales trend improvements across all 3 of our operating divisions.

Our business services division sales grew an impressive 4% in the quarter, and CompuCom sales were up 3% versus the 2017 historical period. We also saw positive trends in Retail, where comparable store sales improved 200 basis points sequentially and were down 2% in the quarter versus the prior year. This is one of our best achievements in many, many years.

One of our critical initiatives this year is to focus on demand generation, and we are seeing the success of these efforts not just on the sales line, but we're also continuing to increase the size of our customer base.

As we mentioned at our Investor Day in May, we have nearly 29 million active customers across the business, and this is an important strategic asset for us. The customer is at the center of all that we do, and continuing to improve their experience is our key to our success, especially as we enhance and expand the number of products and services that we offer as a company. I am extremely proud of our growth in the quarter, and I'm committed to continue this trend in the future.

In addition to strengthening the core, our growth strategy is also focused on creating a powerful omnichannel business services company. Last quarter, we enhanced our financial reporting and started to provide a breakout of product and services revenue across the business. I'm very pleased to report that total services revenue in the second quarter now exceeds 16% of the total company revenue. This is double what it was in 2017.

While much of the year-over-year services growth came from the CompuCom acquisition, I want to highlight that we were also able to grow services revenue outside of CompuCom. Services across our Retail and BSD divisions grew by approximately 8% in the quarter, largely based on the enhanced services and subscription-based offerings we have rolled out this year in those businesses.

The CompuCom acquisition was an important first step in our transformation, but our focus on creating a powerful omnichannel business service company extends across the entire enterprise, as we seek to build broader, deeper and more sustainable relationships with our customers.

Looking at our profitability in the second quarter, GAAP operating income was $48 million, with diluted earnings per share from continuing operations of $0.03 per share. Our adjusted operating income was $63 million, flat with the prior year, while adjusted EBITDA of $115 million was higher than the prior year by $11 million. Adjusted diluted earnings per share from continuing operations was $0.05 per share. Although we're continuing to make growth investments across this business, I'm very pleased that our efficiency and cost control initiatives enabled us to deliver strong profitability.

Lastly, we generated positive free cash flow of $7 million in the quarter, and very importantly, $177 million on a year-to-date basis.

As you know, we generally build inventory in the second quarter ahead of the back-to-school season, so I'm very pleased that we're able to continue building on our free cash flow generation for the year and have built our cash position to $750 million. Joe will provide additional details on the sources and uses of cash in a few minutes, along with an update on the working capital initiatives underway across the business.

I will now elaborate on a few additional highlights in the quarter that support key elements of our strategy and the strategic pivot we are making as a company.

As you will see from the charts on Slide 5, when I first arrived at Office Depot back in early 2017, we were largely seen as a retailer by most investors and analysts. In fact, the majority of our revenue came from the Retail Division. Over the past year, we've put in place a new strategy, acquired new capabilities and built out our management team to execute on our transformation. During that time, we have successfully diversified our business so that our BSD division is now our largest operating unit, and as I mentioned earlier, it is growing. We're also finding that our customer base in the BSD and CompuCom divisions are very similar, which is leading to an increasing pipeline of cross-selling opportunities. Together, these 2 businesses represent approximately 60% of total sales, and we see this continuing to grow in the upcoming years.

We are also broadening and diversifying our business with expansion into services. As I mentioned earlier, services are now approximately 16% of the total sales and have doubled in the past year. Year-to-date, service sales exceed $800 million or over $1.6 billion on an annualized basis. Approximately half of this revenue is related to the award-winning tech services that are performed in the CompuCom division, while the other half generated in our Retail and BSD divisions. We believe that we have the right initiatives in place to continue to grow this piece of our business across all of our operating divisions.

As we highlighted at our Investor Day, we are targeting to grow services revenue to be approximately 20% of total sales in the next couple of years. Most importantly, services have several attractive characteristics as they are generally reoccurring, sticky and carry substantially higher margins than our traditional product offerings. The diversification underway in our business does not mean that we are deemphasizing our retail operations. In fact, I continue to view our retail footprint as a very important component of our omnichannel platform and it is one of our key assets that differentiates us versus online or distribution-only competitors.

Customers continue to see the value of buy online and pick up in store offering, as sales are growing almost 30% year-over-year for this customer choice option. The retail footprint will become even more important in the future as we continue to broaden our product and service offerings and utilize the channel to reach approximately 5.9 million small and medium businesses that are within a 3-mile radius of our stores.

While we're clearly excited by the transformational changes underway across the company, strengthening the core operation establishes the base of customers, earnings and cash flow which we can build upon.

I'd now like to focus my remarks on highlighting some of the initiatives we have underway in the core and the progress we are making to redefine the experience and our offerings and to attract and retain high-value business customers.

As I mentioned, BSD is now our largest division in terms of sales, and as you can see on Slide 6, it has now experienced 2 quarters of positive sales growth. I'm very proud of the team and the success we've had in dramatically changing the trajectory of this business.

There are several factors underpinning this success. First is our focus on demand generation and the shift we made last year toward digital marketing as a way to more efficiently and effectively engage with our customers.

For the second quarter in a row, we've seen positive sales, traffic and conversion rates in our e-commerce business. This is especially important for us, as many customers begin their shopping journey online before ultimately deciding whether to have their purchase delivered by our supply chain or utilize the convenience of our in-store pickup.

Second, we carry this customer-focused mentality into a reorganization of our selling resources last year that is leading to improved customer acquisition and retention. Our field sales teams are now organized around the customers to ensure we tailor our deployment around customer needs. At the highest level, we segment by large enterprise level customers; mid-market customers; and then SMB, our small- and medium-sized customers; and finally, our public sector accounts. In addition, these customer segments are also backed by our inside sales team, who focus on ensuring our customer remote offices receive the same level of service and support as they would get at the corporate headquarters as well as managing stand-alone SMB accounts and identifying both product and service opportunities within the SMB customer space.

Third, we initiated an acquisition strategy in BSD to acquire a number of small, select, independent regional office product dealers in geographies where we had minimal presence. The handful of transactions so far include locations such as Hawaii, Wisconsin, Oklahoma and New Mexico. These markets have attractive customers across all of our segments, including a high number of small- and medium-sized companies. In a buy-versus-build framework, we found this is far more efficient to acquire an in-place selling organization with established customer relationships rather than adding additional centralized selling resources and hoping to displace the incumbent with their local hometown market. Most importantly, we are able to improve the margins of these businesses by leveraging our scale and efficiencies while also offering expanded assortments of products and services.

Lastly, we're seeing continued success in sales growth in our adjacency strategy within BSD. This includes categories such as cleaning and breakroom, copy and print, furniture and technology products.

You will note on Slide 7 that adjacencies now account for approximately 36% of total BSD sales. We began aggressively pursuing this strategy during 2017 and building capabilities across the organization to support this opportunity. This included adding dedicated selling and operational resources with deep industry experience as well as partnering with key vendors to add new SKUs to our assortment in order to capture these share-of-wallet opportunities. We believe the cleaning and breakroom category, in particular, offers significant additional growth opportunities, as the industry is highly fragmented and we generally have a low level of penetration in our existing customer base. Overall, our adjacency business has grown approximately 10% so far this year, and I believe we're still in the early stages of capitalizing on this growth opportunity.

Turning to Slide 8. I'd like to now spend a few minutes walking you through the initiatives underway to strengthen the core of our Retail business. The retail stores play an important role in our omnichannel strategy, as they provide the last-mile advantage to deliver products and an increasing amount of services, all in a convenient location and with knowledgeable associates available to help you with your purchasing decisions. We are investing in several areas to fulfill on this promise and build stronger relationships with our customers and communities in which we operate.

As I mentioned earlier, our marketing efforts are focused on driving demand generation and customer engagement. We are seeing the success of these efforts not just on improving sales trend, but also on underlying metrics such as higher loyalty enrollments, increased download of our mobile app, and most importantly, we're seeing an increase in the number of omnichannel and business customers. We're also using more localized marketing and advertising campaigns to connect with our communities, as well as, for the first time, Spanish language marketing programs to engage with our multicultural customers.

While engaging with customers is the first step, we also know that having knowledgeable and passionate associates in the store is key to our success at retail. We are empowering our store managers to innovate and share ideas with their peers. And last month, we invested in our first-ever Depot Days of Training event, where we had over 20,000 of our associates participate in 2 hours of dedicated training while the stores were closed. The session focused on engaging with customers, various selling techniques and training around our new service and subscription offerings. The program was a huge success, and we are already seeing improvements of our retail customer satisfaction levels. We're planning to run additional training sessions each quarter going forward to continue to build customer-focused selling culture in the stores. Our merchandising teams have also been hard at work launching an innovative assortment of new products and services into the stores.

Most recently, we rolled out our line of home and office automation products as well as a new assortment of PCs that are focused on the higher-end consumer and business customer. In fact, approximately 10% of our sales are coming from products that have been launched this year. This is significantly higher as a percentage compared to recent years and is expected to increase further as we continue to drive innovation into our product and service solutions.

While doing this, we're also reducing excess or obsolete SKUs from the assortment. Most importantly, we're attaching services wherever possible, including in-store and in-home setup and installation services using the thousands of trained and certified CompuCom service technicians. We have also created a number of bundles that include hardware, software and services as a way to provide additional convenience for customers with a total package solution. Longer term, we are evaluating other innovative ways to use the store footprint, including piloting shared workspace at our new Los Gatos store. All of these efforts are ultimately designed to increase traffic, conversion and average order value within the stores.

We also want to drive reoccurring relationships with our customers, and I'm pleased to report that our subscriptions-based offerings continue to grow, and now we have approximately 325,000 subscriptions across the business. We are adding additional categories and functionality to make this an even more convenient service offering for our customers and to create the sticky reoccurring revenue streams that are a key part of our strategy.

As we're getting ready to enter one of our busiest selling seasons, I want to spend a few minutes on back-to-school. You will see on Slide 9 that we have built on the learnings from last year, and we made several major improvements to this year's back-to-school season.

One of the key changes we made was to be out in the market much earlier. In fact, we believe we were the first to launch nationwide and had the stores set beginning at week 20 or the third week of May. This is significantly earlier than our week 28 launch from last year, when many shoppers had already been out in the market.

Second, we have changed our promotions this year from a high-low strategy to one that is based on value pricing all season long. Instead of promotions with restrictions and limited availability, we'll be offering competitive pricing on a broad assortment of core supplies throughout the entire back-to-school season so that customers can rely on us for the value they have come to expect.

We have also increased our focus from beyond the traditional K through 5 market to the broader kindergarten to college market in order to capitalize on the higher-spending segments with specific products and marketing focus on students, parents and teachers. This year, we are expanding our omnichannel offerings and capabilities so that customers can shop the same assortment online as well as in our stores, and then choose to have it delivered or use the convenience of buy online and pick up in store offering.

We also added enhanced school list functionality, with thousands of school lists available that can be added to your shopping cart with a single click.

Lastly, we have new partnerships in place, including a sponsorship with the National PTA that allows us access to their 3.5 million members; and an innovative partnership with Disney's Sabrina Carpenter, where she will be posting Office Depot messages across her social media platform, including to her 14 million Instagram followers.

I am proud that we have a new philanthropic program in place called Start Proud, where Office Depot will be contributing school supplies to students, parents and teachers at selected Title 1 schools across the country and allow shoppers in our stores to also contribute to this worthwhile cause.

Overall, I believe we are well-positioned for the back-to-school season and have a very competitive and compelling program in place this year that also builds on the efforts to change the retail store experience that I mentioned earlier.

Turning to Slide 10. I'm very pleased that sales in the CompuCom division increased for the second quarter in a row versus their historic results. This is a significant accomplishment, as growth with new and existing customers more than offset the decline they are experiencing with one of their largest clients, who is undergoing a significant restructuring. In fact, CompuCom's large account wins in the first half of 2018 have already exceeded the full year total from last year. I'm really pleased with that. And we will continue to drive services revenue in this business, and we have now experienced 4 quarters of year-over-year growth in service orders. We are continuing to make investments in order to capitalize on what we believe is a significant future growth opportunity for this business.

As I mentioned last quarter, the 2 sales teams now have been fully trained and are tracking hundreds of opportunities, and the momentum is building. We highlighted several of these new wins at our recent Investor Day, including the success we are seeing in the education vertical, where we can leverage Office Depot's strong market position and customer relationships. We have also recently expanded our relationship with a modest-sized office supply customer and that turned into a new multimillion dollar IT service relationship. This shows the potential of cross-selling across our businesses. We have an incentive structure in place that is specifically focused on driving services revenue and cross-selling opportunities across our business, and I expect the cross-selling opportunities to continue to ramp over the balance of the year.

We have scaled our tech services to be more relevant in SMBs, including the launch of our device-managed service contracts for small business and a new IT-as-a-service offering for businesses from 1 to 250 employees that was recently rolled out. This offer is perfect for customers who need an IT adviser and want to optimize their IT spend with centralized support.

Importantly, it is built around a monthly per user subscription model. We are continuing to deploy tech services across our retail chain and have device-managed service contracts live in all of our retail stores as well as online, and we are continuing to develop additional new service offerings to address the unique needs of SMB customers.

A great example is a tech dispatch and in-home installation services that we now offer to set up your device at your home or your office. Overall, I am pleased with our progress integrating the CompuCom offerings into our broader services portfolio. CompuCom is an important strategic asset for us as a company, and it provides us unique capabilities that truly differentiates us from the competition and positions us for additional opportunities that we could not pursue without them.

I will now turn the call over to our CFO, Joe Lower, who will provide more details on our financial results. Joe?

Thank you, Gerry, and good morning, everyone. I'm happy to be here today to discuss with you our second quarter results.

Similar to last quarter, we have provided our results on both a GAAP basis and an adjusted basis from continuing operations. My comments will primarily address the performance from our continuing operations on an adjusted basis.

Also, keep in mind that the total company financials include the results for CompuCom division for the second quarter of 2018 only, as this business was not part of Office Depot in the prior year period.

Turning to Slide 12. We have highlighted some key performance measures for the second quarter of 2018. Total company sales for the second quarter totaled $2.63 billion compared to $2.36 billion in the same period last year. The increase of 11% was driven by the addition of CompuCom's results for the second quarter in 2018 as well as continued sales growth in our Business Solutions Division.

Product sales in the second quarter were up 1% while service revenues grew 120%, driven primarily by the CompuCom acquisition. However, I'd also like to point out that service revenue excluding CompuCom grew 8% in the second quarter, based on the company's strategic efforts to grow overall business services revenue. As Gerry mentioned earlier, services now make up approximately 16% of total company sales.

Second quarter GAAP operating income increased to $48 million compared to $41 million in the prior year. During the quarter, the company incurred $15 million of operating expenses related to merger, integration, acquisition-related costs and other restructuring activities. Excluding these items, our adjusted operating income in the second quarter of 2018 was $63 million and flat compared to the prior year. Both periods include a negative impact due to the change in accounting standards related to the presentation of expense related to defined benefit pension plans. The impact was $2 million in the second quarter of 2018 and $5 million in the second quarter of 2017.

Adjusted EBITDA was $115 million in the second quarter compared to $104 million in the prior year. The $11 million increase was primarily associated with higher depreciation and amortization expense associated with the CompuCom acquisition that did not exist in the prior year.

Excluding the after-tax impact from the items mentioned above, second quarter adjusted net income from continuing operations was $30 million or $0.05 per share compared to $34 million or $0.06 per share in the prior year.

Finally, for the second quarter of 2018, cash provided by operating activities of continuing operations was $44 million, with free cash flow of $7 million.

On a year-to-date basis, our company-wide focus on working capital has allowed us to generate $251 million in operating cash flow, with $177 million of free cash flow.

Overall, we are very pleased with our earnings and cash flow performance through the first half of the year, and we are well on our way to achieving our full year targets.

Let's now turn to Slide 13, which highlights the performance of our Business Solutions Division, or BSD. Reported sales in the second quarter for BSD were $1.3 billion, an increase of 4% compared to the prior year. The year-over-year increase reflects our stated strategy of selectively acquiring niche players in localized markets, coupled with flat performance year-over-year in our core business.

Product sales in the second quarter increased 3% versus the prior year, while services revenue increased 15%, again reflecting our focus on increasing business services across the entire business. We continue to see strength in our adjacency categories and our e-commerce channel.

Of important note, Q2 results for BSD reflect a quarterly sequential improvement of approximately 300 basis points and continues the trend in positive sales growth that started in the first quarter of this year. The sequential improvement was driven by growth in supplies and services, a very encouraging trend that reflects a concerted effort by our sales team.

The BSD division reported operating income of $67 million in the second quarter of 2018 compared to $64 million in the prior year period. The increase in operating income versus the prior year was primarily driven by higher sales volumes as well as the benefit of cost-reduction initiatives that have been implemented over the past year. I am very pleased that we were able to grow operating income in the quarter while we continue to make incremental marketing investments as part of the company's intense focus on increasing online demand generation.

Turning to Slide 14. Reported sales in the second quarter for the Retail Division declined 5% to $1.05 billion compared to $1.1 billion in the prior year period. The decline in sales was partly due to the impact of store closures over the past 12 months as well as a negative impact to revenue of approximately $10 million resulting from the adoption of the new revenue recognition standard.

Comparable store sales decreased 2% versus the prior year, primarily driven by fewer transactions and lower average order values. This is a sequential quarterly improvement of approximately 200 basis points compared to the first quarter of 2018. Our Q2 results in Retail reflect the continuing positive trend of buying online, picking up in store that grew almost 30% year-over-year. Again, this reflects our concerted effort to generate incremental demand via our digital marketing efforts and the value of our omnichannel platform.

Product sales in the second quarter decreased 7% while service revenue increased 12% compared to the prior year period, excluding the revenue recognition impact.

Looking at our performance by category. Sales increased in the cleaning and breakroom and copy and print categories, with declines in technology, supplies and furniture.

The Retail Division reported operating income of $22 million in the second quarter of 2018, an increase of $2 million compared to the prior year period. This year-over-year increase, despite lower sales, was primarily driven by the positive impact of ongoing efficiency and cost-reduction initiatives, which more than offset the negative flow-through impact from lower volume.

During the second quarter, we closed 2 stores, bringing our total store count to 1,374 stores in the Retail Division.

Looking at Slide 15, we highlight the performance of the CompuCom division. As I mentioned earlier, reported financials include the results for CompuCom in the second quarter of 2018 only, as this business was not part of Office Depot in the prior year period. However, to provide greater perspective into the year-over-year performance of this business, we have presented unaudited adjusted historical results for the second quarter of 2017 for reference purposes only.

The adjustments made to the 2017 results take into account the treatment of historical restructuring and acquisition costs to more closely align with Office Depot's reporting format.

Reported sales in the second quarter for the CompuCom division were $277 million, up 3% versus historical sales of $269 million in the prior year period. The business experienced sales growth in both product and services. And as Gerry mentioned earlier, this was the fourth consecutive quarter of year-over-year growth in service orders.

The sales performance was particularly impressive given the decline in sales from one of the largest enterprise customers, as that client is going through a significant restructuring, with an associated reduction in demand for CompuCom services.

The CompuCom division reported operating income of $6 million in the second quarter of 2018 compared to $16 million in the adjusted historical results. The decline in the quarter was primarily due to lower gross margin on sales to new customers in the period and ongoing investments to support growth initiatives as well as incremental depreciation and amortization expense related to the acquisition and expenses related to the alignment of accounting policies. This was partially offset by lower selling, general and administrative expenses as a result of targeted cost-reduction initiatives and synergies realized from the acquisition. Unfortunately, the cost of acquiring and implementing new business tends to be more front-end loaded, which impacted profitability in the quarter.

In addition, we continue to invest to build capabilities and improve operations as we position the business for more profitable growth going forward. We are committed to driving improved profitability and expect margins to improve.

Turning to the balance sheet and cash flow highlights on Slide 16. We ended the second quarter of 2018 with total liquidity of $1.7 billion, consisting of $700 million in cash and cash equivalents and $1 billion of availability under our asset-based lending facility. Total debt at the end of the quarter was approximately $1 billion, excluding $765 million in nonrecourse debt related to the timber notes.

For the second quarter of 2018, cash provided by operating activities of continuing operations was $44 million. As I highlighted earlier, the year-over-year increase was primarily due to continued working capital improvements and included outflows of approximately $7 million in OfficeMax merger costs, $5 million in acquisition and integration-related costs and $3 million in restructuring costs.

Capital expenditures were $37 million in the second quarter of 2018. The investments reflected our commitment to continue to strengthen our core as well as invest in future growth.

Incorporating capital expenditures, we have generated robust free cash flow from continuing operations of $177 million year-to-date in 2018.

Underlying our strong free cash flow generation was over $150 million in year-over-year improvements in working capital, reflecting our concerted efforts to extend payment terms, improve our collection process, increase inventory turns and reduce excess inventory.

In addition, during the second quarter, the company paid a cash dividend of $0.025 per share to shareholders on June 15 for approximately $14 million in total. We also repaid $19 million of our outstanding term loan, consistent with the repayment schedule.

In addition, we reinitiated our share repurchase program and repurchased approximately 3 million shares at a total cost of $8 million in the second quarter of 2018. This reflects our balanced capital redeployment strategy within the constraints of our term loan agreement.

Furthermore, as previously announced on our call last quarter, we successfully completed the sale of our business in Australia in February and closed on the sale of our New Zealand business in May. The sale of both businesses will provide the company with approximately $115 million of incremental cash to continuing operations. As we discussed previously, approximately $50 million of these proceeds are available for us to use for share repurchase, which we will do selectively. With these 2 transactions now finalized, the company has fully completed the international divestiture plan.

Looking at Slide 17, we continue to expect a full year outlook consisting of sales of approximately $10.8 billion, adjusted operating income for the year of approximately $360 million and free cash flow of approximately $350 million. With a strong Q2 performance and momentum we are seeing with our key growth initiatives, we feel confident that we are well on our way to achieving these targets. Our teams remain focused on this transformation journey, and we believe we are taking the necessary actions to position the company for long-term sustainable growth.

With that, I'll turn the call back to Gerry for his closing comments. Gerry?

Thanks, Joe. Overall, I'm very pleased with our second quarter performance and continue to believe that we have the right long-term strategy in place. Importantly, we are continuing to see momentum behind building our key initiatives, including stabilizing the core of our business as evidenced by the sales trend improvements we saw this quarter in all 3 of our operating divisions. Second, the aggressive demand generation strategy that is benefiting all of our channels, driving significant improvements in online traffic and increasing the number of active business customers across the enterprise. Third, the shift we are making to a more reoccurring and services-based model, as evidenced by the continued growth of our service and subscription offerings. And finally, the strong progress we are making at driving working capital improvements and free cash flow generation as we drive toward our target of delivering $350 million of free cash flow this year.

I will now turn the call back over to the operator, and we can take your questions.

(Operator Instructions) Our first question comes from the line of Matt Fassler.

This is Chandni Luthra on behalf of Matt Fassler from Goldman Sachs. I have a very quick question -- a couple of questions for you. Within the BSD segment, overall, what customer segments would you say drove the maximum improvement? Would it be your small customers, large enterprise, K-12 or hospitality? Or how would you order those?

This is Gerry. Thanks for joining this morning, and in fact, we saw strength across all segments. All -- Steve's team did a fantastic job. Our adjacency business, led by David Centrella, did a fantastic job. They've grown that to 36%. We've seen a lot of strength there. SMB is strong, as well as enterprise as well. Public is -- this -- Q3 is a bigger season for public, but -- and so we're super strong with -- it's really a 1,000 basis point improvement since Q2 of last year. And it's the digital engine, it's how we've organized and it's really the cadence of the adjacencies and the federation strategy as well, but one thing I really want to highlight is our core business, our core is flat, approximately flat, and that's a huge achievement from where we were 12 months ago.

That's very helpful. And then within that segment, again, looking into profits, I'm curious if the OfficeMax business -- did it have any negative impact? Or have you guys like fully digested it now?

It's completely integrated from an overall integration perspective, so no impact. And just, again, yes, super happy with Steve and his team's ability to grow profitability on a year-over-year basis in BSD. That's a huge achievement, while growing.

As we commented last quarter, most of the final conversions were completed last quarter. So as Gerry said, we really don't anticipate any significant costs going forward from those activities.

So I guess, if I were to rephrase my question and basically ask as you've sort of fully digested it, what sort of improvement did it drive on your BSD profitability? Any way to quantify that? Sorry, go ahead.

Yes, just from a -- again, it's -- all segments, including public, had very, very strong quarters. When you start growing as a business, you get the scaling of expenses. We obviously did a lot of work on -- over the last 1.5 years on SG&A. And Steve and his entire team have done a good job. So whether it's enterprise and Tom, and Claudia in SMB, or Sue in education, or Dave from an adjacency perspective or our federation, all these groups grew and all of them had profitability increases. Joe, would you add any other comments?

Our next question comes from the line of Michael Lasser.

I'm from UBS. So last quarter, you said that BSD ex acquisitions was down slightly. This quarter, you said it was flat. So can you describe a little bit more about the sequential change? It sounds like it's similar, so are you seeing stabilization in your win/loss rate? Are you growing your customer accounts? Are you winning new business? Can you give us more -- a greater sense about how BSD is doing ex acquisitions. And is this the right -- is flattish the right run rate to think about?

Yes, I mean, just overall, and I'll let Joe comment as well, but we did grow sequentially from a core perspective on BSD. And we were, in the last quarter -- and so we're up to -- the overall BSD business without our federation piece is basically flat, and that's an improvement from last quarter. And obviously, a lot of that's -- it's a number of factors, it's driving acquisition wins. It's obviously new logos, and really, really importantly, it is the growth in adjacency and services in BSD. Both adjacencies is now a larger mix and that's cleaning and breakroom, technology, furniture, copy and print, all those sectors are growing. And again, that's one of our factors. And to be honest, services in BSD is growing as well. So -- and obviously, those are both higher profit margin, higher gross margin businesses. Then obviously, on top of that, we've had good success with our federation strategy. So I am super bullish and super optimistic with the fact that we have a 4% growth in B2B, and now 61% of our overall business is really B2B businesses when you add services in. So we are truly an omnichannel company, and we're seeing growth. And to be honest, we're going to be optimistic going forward with that business, and we're going to continue this trend as well. Joe, would you like to add anything?

The only thing I'd add is that as well in addition to the services and the adjacencies, we've also continued to see positive trends in our e-commerce business. And so I think if you look at those 3 drivers, it clearly is making a difference quarter-over-quarter.

And as Joe said, I mean, higher customers, higher traffic, higher conversion, 2 quarters in a row in e-commerce. And as you know, people start first on their phone, and so it's very, very important to have an online, competitive offering, and Natalie and Jerri and team have done a fantastic job.

And if all those pieces of business are growing to drive an outcome that's flat, something has to be declining to offset those gains. So what in the BSD division, excluding acquisitions, has been still under pressure?

I don't think there is. I'm confused a little bit with the question, Michael. But I mean, we weren't flat year-over-year. I mean, we were flat year-over-year overall from the core, which was a huge achievement. And I think it's -- obviously, it's getting growth. It's -- from a historical perspective, it's the sequential growth that's very, very positive for the overall business. If we go back to where we were a year ago, and we just -- we've said all along to you and the team at Investor Day, that we're going to sequentially improve the business through demand generation, through our focused reorganization, through our online capabilities and just better customer experience as well in our adjacencies, and we've done all that. And so -- and growing the business overall 4% is part of the strategy, and we're going to be optimistic that all -- we're going to continue to grow across all elements of the business.

Yes, Michael, what I can say is this. Some of the traditional areas of the business, obviously, are under a different kind of environment. And so I'd say that is offsetting some of the positives we talked about. So net-net, it's flat, but it is some of the more traditional areas that continue to face market pressure.

Which is why the diversification to adjacency and services is so important.

If I could add a follow-up question, it's on the Retail business. So that improved by a couple hundred basis points from a comp perspective versus where it was in the first quarter. You provided a lot of detail in your prepared remarks, but what specifically drove that sequential improvement in Retail? And it's important for us to understand how sustainable that is. As an example, could this get to the point where it's just flat year-over-year? And what would drive that?

Well, the goal, obviously, is to get to that point, absolutely. And we're not going to commit to that, but we're -- there is a cadence in place, and Kevin Moffitt and the leadership team in Retail have done a great job, but I'll address some areas. Number one, we've really worked on introducing more innovative products, we're up to 10% of our products are now new in stores and that's a huge increase from where we were 1.5 years ago. Second, very importantly, buy online and pick up in store has grown 30%. Third, we made investments in the stores themselves. We have new Internet. We have lighting. We put investments in infrastructure to make it a better experience. And most importantly, Kevin and his team have really refocused on putting the customer first. We want to meet and greet. We want to sell versus stock. We want to make sure we really understand the customer as they walk in the store, and not only sell them products but sell them services as well. You saw the 325,000 subscriptions. That's primarily done at retail. And to be honest, that's the gift that keeps giving, and those are monthly subscriptions that we're going to continue to build and we have a very aggressive goal of that internally. But our device-managed service, our installation that we mentioned, our virtual CIO, our copy and print, all those things are important to build this foundation. We think those are key. It's innovation, it's the services, it's the subscription, it's the customer-first mentality. And we're very confident over time we're going to continue to improve this trend.

So it was really the contribution from services. It wasn't about rest of the business getting less bad?

It's services. It's buy online, pick up in store. And I'll say it's a focus on driving sales with the customer. It's a mentality culture shift, and that's really driven by our overall team and Kevin Moffitt's done a fantastic job of driving that business and having that change in mindset. When you walk in the store, I want someone meeting you at the store and selling to you our services and our products.

(Operator Instructions)

I want to thank everyone, and again, I'm really very, very -- really proud of this team for growing the business, for our outstanding free cash flow. We're continuing to grow the services. We've grown adjacencies. And we feel that Office Depot is very well-positioned for the rest of the year. And I'm really proud of the team and our execution of our strategy. Thank you, everyone, and have a great day, and we'll see you in November.

Thank you for your participation. This concludes today's conference call. You may now disconnect.