The ODP Corporation
Q1 2007 Earnings Call Transcript

Published: 26 Apr 2007

[Operator:]

Good morning and welcome to the First Quarter 2007 Earnings Call. All lines will be on a listen-only mode for today's presentation, after which instructions will be given in order to ask a question. At the request of Office Depot, today's conference is being recorded. I would like to introduce Mr. Ray Tharpe, Director of Investor Relations, who will make a few opening comments. Mr. Tharpe, you may now begin.

[Ray Tharpe:]

Thank you and good morning. Before beginning today's conference call, I would remind you that certain statements made during this call are forward-looking statements under the Private Securities Litigation Reform Act. Except for historical, financial and business performance information, comments made during this call should be considered forward-looking. Actual future results may differ materially from those discussed on this call due to risks and uncertainties, both foreseen and unforeseen. Certain risks and uncertainties are described in detail in our report on Form 10-K filed with the SEC on February 14, 2007 and in our Form 10-Q filed this morning. During portions of this call, we may refer to results which are not GAAP numbers. A reconciliation of non-GAAP numbers to GAAP results is available on the Investor Relations area of our website at www.officedepot.com. Now, I would like to introduce Office Depot's Chairman and CEO, Steve Odland.

[Steve Odland:]

Thank you and thank you for joining us today; for Office Depot's fiscal 2007 first quarter conference call. With me today are Pat McKay, Executive Vice President and Chief Financial Officer; Chuck Rubin, our President of North American Retail and Ray Tharpe from Investor Relations. I hope you've had an opportunity to read our press release and learn about the first quarter results. If not, the press release along with accompanying webcast slides, are available on our website at www.officedepot.com. Just click on the company information and then Investor Relations. First quarter sales grew 7% to $4.1 billion compared to the first quarter of 2006. Sales in North America were up 3%, while international sales increased 21% in US dollars and 11% in local currency. North American retail comparable store sales were down 3% for the quarter. Our North American businesses were depressed by a few factors during the quarter, the launch of Microsoft Windows Vista Operating System and a continuation of the slowdown in housing sales and the softening in small business spending later in the quarter. The North American Retail Division has a heavy tech weighting, whereas this is a relatively undeveloped category in the international division. As such, North American retail comps were materially impacted by the lack of supply of computers in the quarter driven by Microsoft Windows Vista change-over on January 30th. Subsequent to the Vista transition, retail comps have rebounded but not enough to offset its negative impact in January of the reduced technology and related sales. North American retail division as well as the North American Business Solutions division has seen a softening in small business spending. The trend in office furniture purchased mostly for small and home offices continued downward as January represented the 14th consecutive month of year-over-year declines in total home sales. Despite these soft market conditions, independent analyses indicate the Office Depot maintained market share among office supply stores during the quarter. Office Depot recorded charges in the first quarter of both years associated with the implementation of plans announced in 2005 and disclosed in our previous SEC filings. Excluding certain items from both periods, from the first quarter charges, net earnings as adjusted increased to $168 million in the first quarter of 2007 from a $144 million in 2006 or 17%. Despite the challenges of the first quarter, we are very pleased to report an increase in diluted earnings per share as adjusted by 25% to $0.60 per share from $0.48 per share in the same period last year. Gross margin declined 40 basis points due to the lower margins from acquisitions, higher paper costs, and a shift in mix in North American business solutions and international. Operating expenses decreased as a percentage of sales by 70 basis points due to the leverage of higher sales and expense controls. EBIT as adjusted was $249 million for the quarter or 6.1% as a percentage of sales, up 40 basis points as compared to the prior year period. Our as adjusted effective tax rate for the quarter was 29.4% and we currently expect a full year effective tax rate between 29 and 30%. Net earnings for the quarter on a GAAP basis were $156 million compared to earnings of $130 million in the same period of 2006, which is an increase of 20%. GAAP EPS on a diluted basis were $0.56 for the quarter versus $0.43 in the first quarter of 2006, which is an increase of 30%. First quarter charges had a negative effect on EPS in both years; $0.04 per share in 2007 and $0.05 per share in 2006. We recognized $12 million of charges during the first quarter and anticipate charges of approximately $60 million for the remainder of 2007 and $37 million in 2008. However future charges may change as plans are implemented. We have provided a reconciliation of GAAP to non-GAAP results which you can access on our website www.officedepot.com under the Company Information section and then Investor Relations. Now Chuck Rubin will take you through the first quarter results of the North American retail division. Chuck?

[Chuck Rubin:]

Thanks Steve. First quarter sales in the North American retail division increased 3% to $1.8 billion. However comparable store sales in the 1042 in the US and Canada, that have been opened for more than one year decreased 3% for the quarter. Comps were negatively impacted during the quarter by the disruption in PC sales caused by the launch of the Microsoft Windows Vista operating system at the end of January and a softening in business spending, particularly in furniture sales to small and home office customers. As we previously discussed, the launch of the new Vista operating system during the first quarter essentially halted sales of laptops and PCs in the month of January as manufacturers depleted supplies of pre-Vista units and Vista equipped units were embargoed until January 30. Net sales improved after the January 30 launch and returned to the levels we had seen prior to the impact of the Vista launch. However these sales levels were not able to make up for the significant short fall experienced in January. A recent poll by Harris Interactive found that only 12% of respondents said that they plan to upgrade to Vista within the next 12 months and only 20% said Vista caused them to buy a PC sooner than they had planned. Main reason cited for the reluctance to upgrade were fear of software bugs and compatibility with other hardware and software. Over time we believe we could see an increase in laptop and PC sales as our business customers become more comfortable with the interoperability of their existing software applications in the Vista operating system. And then ultimately the enhanced security that Vista provides will also motivate many of our customers to upgrade their operating systems in their computers. A lack of traffic due to the technology sales decline associated with the Vista launch also negatively impacted sales of products and categories including those that are directly and indirectly associated with the sale of computers. Furniture continued to experience soft sales and accounted for over a 150 basis points of impact to our overall comp sales decreases we believe continued softness in the housing market has negatively impacted our home office furniture sales. Average ticket size continued to increase. Comparable average sales per square foot were $265 for the quarter. Despite these challenges the North American retail division generated a 15% increase in operating profit of $155 million for the first quarter of 2007 compared to $135 million in the same period of the prior year. Higher product margins, expense leverage, cost management initiatives and a slightly lower remodeling cost, helped to drive expanded operating profit margins to 8.4%, an improvement of 90 basis points from 7.5% in the prior year period. Inventory per store was $946,000 as of the end of the first quarter of 2007, a little higher than the same period last year due to early stocking of next generation PCs and laptops at the end of the quarter. We remain pleased with the results of our overall remodeling efforts completing 80 remodels in the quarter. These remodeling activities have a short-term negative impact in our retail results but represent an important part of our longer term retail profitable growth strategy. We exclude a brief remodel period from our comps to account partially for some of the disruption. In addition to the remodels, we also opened 16 new Office Depot stores during the quarter. At the end of the first quarter, Office Depot operated a total of 1,174 Office product stores throughout the US and Canada. Our current plans are to open approximately 150 stores this year. We also anticipate opening approximately 200 stores in 2008. Most of these stores will be opened as fill-ins in markets in which we currently operate. We continue to be very disciplined in evaluating both individual new store openings and our overall execution strategy based on our hurdle rate. Our financial model recognizes that the opening of stores as fill-ins is like to negatively impact sales of existing stores. As an example, comp sales in the second quarter of 2007 were negatively impacted by approximately 50 basis points in the quarter by the effect of these fill-ins. Despite this impact, the impact on the total market is positive and the net effect hurdles our IRR. We feel it is important to maintain and strengthen our market position in core market areas and remain committed to doing so. To help you better understand our new store productivity, our stores mature over the course of approximately 5 years with first year sales equal to about 67% of this expected sales and maturity. In the first quarter, we completed remodeling 80 stores. As we stated last quarter, our goal is to remodel substantially all remaining North American retail stores within the next few years. As of March 31st, approximately 570 of the 1174 stores in North America were operating M2 format. Our Design Print and Ship business continue to grow as we increased customer awareness through print and broadcast advertising in the first quarter. We are providing our store managers with flyers explaining the capabilities of our Design, Print and Ship business. Store managers are using these flyers to market to local business organizations in the communities surrounding their stores. Sales now average approximately $250,000 per store for this highly profitable and growing business category. We continue to expand private brand penetration in the first quarter as furniture, supplies, and technology all had positive private brand comps for the quarter. In February, we introduced a new collection of furniture in North America. The collection, which utilizes an innovative [hinged] assembly method that significantly reduces set-up time and effort, is constructed of solid wood and veneers. During the quarter, we also introduced a new premium tier private brand writing instruments called Foray Focus. This premium tier is initially represented by eight new products. Private brand for [sent] penetration to North American retail has increased to the mid 20s, and we believe there is substantial opportunity for further penetration growth as we continue to expand our assortment in each of our brands. While improving product margins, increasing private brand penetration, negatively impacted comp sales by over 30 basis points in the first quarter Also during the first quarter, we shifted numerous mail-in rebates to instant rebates. This was part of our overall effort to optimize the value proposition and buying experience for our customers. However this shift did negatively impact sales comps by 40 basis points in the first quarter. We've rolled out in-home and in-office technology installation services on a nationwide basis. We also continue to pirate in-store technology services with the Geek Squad in our Orlando and Denver markets and we will likely expand this service more broadly. We are pleased with the results so far. We remain committed to profitably expanding our presence in existing markets as well as selectively targeting new markets, where we see opportunities for profitable growth. We believe that the deployment of capital for new stores and remodeling of our existing stores, coupled with other marketing and merchandising growth initiatives should enable our North American Retail division to continue to deliver profitable sales growth and build shareholder value into the future. Now, I would like to turn the call over to Pat McKay.

[Pat McKay:]

Thanks Chuck. North American Business Solutions division sales increased by 3% compared to the first quarter of last year. First quarter 2007 revenue reflects growth in the contract channel of 10% including our Allied acquisition completed in 2006, which more offset expected declines from the direct channels from our brands consolidation efforts which deliberately reduced unprofitable business. As with retail, sales in this division were impacted by a softening in business spending, particularly in small and medium sized businesses; which is continuing into the second quarter. The run rate of sales in former Allied Office products customers, mostly in the New York City area, is down significantly from pre-acquisition. This largely is due to the loss of the significant number of sales people in New York during the acquisition process, mostly to smaller competitors and many of whom were significantly out of sync with Office Depot's compensation systems or [had acted of] Independent Contractors under Allied management. We also lost some customers due to service issues in the quarter, as we closed the former Allied distribution center in New York and transition fulfillment to Office Depot distribution centers. Previous integration efforts in markets throughout the country had gone well until this last facility. While none of this was unexpected, we always want things to go smoothly as possible during transitions and we don't like disappointing any customers. We are not happy with the way this New York integration went, and we are working very hard to win back that volume. We have restructured our supply chain organization to enhance the service to these new customers in the Northeast and the good news is that most of these customers have multiple suppliers and can flex their purchases back to us as our service problems are resolved. As of now, we have resolved most of the service issues, and are launching new marketing efforts to win this business back and our hiring additional sales people to derive this process. The North American Business Solutions Division had an operating profit of $73 million for the first quarter of 2007 as compared to $94 million in the same period of the prior year. Operating margins declined as expected for the first quarter of 2007, reflecting a continuation of the temporarily higher expense levels that were associated with an investment in the expansion of both our contract sales force as well as the implementation cost associated with a new furniture delivery program. These expenses which significantly raised our operating costs in the first quarter are expected to moderate over the next few quarters. Continued softness in small business spending will delay operating margin recovery efforts. Therefore the BFT operating margin in quarter two should be down versus a year ago roughly the same amount with the recovery efforts in the second half of this year. The additions we made to our sales force in the fourth quarter are progressing through their training and are becoming productive contributors in the field, pursuing new profitable customer sale. We expect new sales personal to be fully self supporting with a 9 to 12 months of joining our business Solutions Division. We have also made excellent progress in the role out of our new Enhanced Furniture Delivery Service. The service will improve on time deliveries to the location of the customers choosing and perform that light assembly and packaging removal services. We believe that furniture delivery will further differentiate our furniture offering from that of our competition. But short-term this has a cost of about 25 basis points in margin for the quarter. Leveraging a competency that we obtained in the Allied acquisition, we have begun to compile copy service offerings in select markets. These offerings will enhance our current break room position with small and medium sized customers. We also continue to focus our selling resource on profitable service initiatives, like the enhancement of our print offering. We are now able to provide file cabinet functionality, enabling our customer base to store documents online, and make changes to the documents and print them on an as needed basis. The delivery segment of the Office products industry is highly fragmented and we are pursuing new profitable customers in this channel, mostly through organic means. Our internet sales continue to grow in 2007 with sales for the previous 12 months, totaling $4.5 billion, compared to $3.8 billion a year ago. Clearly the North American business solutions division has been challenged this past quarter and will continue to be so in the second quarter. But we are taking the appropriate steps to direct the issue to invest and develop this business and to derive long term profitable growth.

[Steve Odland:]

Let us now turn the discussion to focus on our international division. International division's first quarter sales of $1.1 billion increased 21% in US dollars compared to the first quarter of 2006. Local currency sales including 2006 acquisitions increased 11% over prior year. Importantly all channels contributed to positive growth and the division has realized its fifth straight quarter of sales growth in local currencies. Notably contract increased by 9% versus the same period last year reflecting our focus on new account acquisitions as well as expanding sales with existing customers. Division operating profit was $82 million in the first quarter of 2007 compared to $69 million in the prior year's first quarter. Operating profit was down slightly to 7.6% in the first quarter of 2007. Excluding acquisitions, operating margins for the division expanded by 50 basis points. We anticipate that lower operating margins realized in our recent acquisitions will expand from their current levels as we execute our plans to leverage purchasing power and extract the planned synergies. During the first quarter the international division continued to execute against several initiatives to drive profitable growth. We redesigned into the contract selling model to improve effectiveness and deliver more targeted value propositions to the customer. To drive incremental sales across Europe and Asia, we continued to expand our use of telephone account managers and are doubling our sales force in China. These efforts contributed to the significant growth experienced in our contract sales channel during the quarter. In the direct channel, we also developed new offerings designed to attract new customers and strengthen relationships with existing customers. Examples of these offerings include the European Green Book which highlights environmentally friendly Office products as well as the work and life trends, lifestyle products catalog which has been successful in Germany. We have expanded our international retail presence, opening six stores in Asia and five in Europe. Similar to our North American retail strategy, these stores are optimizing our density in the markets we currently serve and utilizing in M2 prototype that's customized to that individual market. We have made great progress in establishing our regional offices in Asia and Latin America. We have opened our regional office in Hong Kong, outsourcing office in Shenzhen, China and we have already transitioned several of the large Chinese vendors from our former third-party sourcing agent to our Shenzhen sourcing office. Finally, we are pleased to announce that we have hired a Managing Director for our Latin American operations and are establishing a Latin American regional office, co-located with our global headquarters in South Florida. During the first quarter we opened an office in Poland which will allow us to serve many of our international customers with operations in that country. We continue to assess further geographic expansion through acquisitions and alliances in targeted markets. International division has made good progress against its cost management initiatives in the quarter. We centralized our supply chain management structure in Europe consolidating what had been 15 separate planning functions. We also successfully converted our warehouse in Ireland to our Global Warehouse Management platform. We implemented several processes during the quarter to reduce spending due to tighter expense controls. Examples of these processes are standardizing printers and warehouses across Europe and automating the process for receiving of fax orders. We've been able to reduce some of our inventory carrying cost to the implementation of a virtual stock program. Virtual stock allows us to continue to provide our customers with a wide variety of products including those products that are not in high demand, without holding the product in our warehouse for long period of time. We've also effectively implemented standardized tools for product pricing and marketing spend. These tools have been successfully in place in North America and were selected to be part of our global suite of applications. And finally we have completed renegotiating master purchasing agreements with our European vendors. We now have agreements that are consistent across countries and that recognizes our pan-European presence. We are very pleased with the progress that we've made this quarter in international cost initiatives and we look to continually increase our operating efficiency in Europe, Asia and Latin America. Now Pat McKay will take you through the cash flow and balance sheet.

[Pat McKay:]

For the quarter, free cash flow before share repurchases was $127 million versus $211 million in the prior year, a greater amount of cash flow was used this year for investments made in our core businesses. And cash provided by operating activities was $231 million compared to $268 million in the prior year. Depreciation and amortization totaled $72 million for the quarter, down slightly from $75 million in the same period last year. Adjusted EBITDA was $321 million, an increase of 10% when compared to adjusted EBITDA last year. Capital expenditures for the quarter were $104 million, up from last year due to the implementation of previously announced plans to profitably grow our business. We now expect capital expenditures for 2007 to be about $500 million or about $100 million lower than the number we provide last quarter and we have lowered our estimates for 2008 expenditures to around $600 million and also would share with you that we expect CapEx to be approximately $500 million in 2009 as we continue to evaluate capital spending in accordance with our financial guidelines and refine the lease versus buy divisions. As we previously said, we may refine these estimates overtime as we evaluate them based on our hurdle criteria. During the quarter we have repurchased approximately 2.6 million shares of our common stock at an average price of $35 or $90 million in total. Subsequent to the end of the quarter, the $110 million remaining authorized for repurchases was substantially completed. Additionally the Board approved an additional $500 million authorization to repurchase shares. Now on to the balance sheet; we ended the first quarter with $194 million in cash and short-term investments. Our investment and inventory totaled $1.6 billion globally. Our first quarter inventory includes inventory associated with recent acquisitions. We ended the first quarter with average inventory per North American store of $946,000 a little higher than the same period last year due to the early receipt of next generation computers and notebooks at the end of the quarter. Working capital increased by 34% as compared to the first quarter of the prior year, but excluding the impact of our adoption of FIN 48, working capital increased by 15% which reflects the effective acquisitions completed in the prior year. Our accounts payable to inventory ratio remained relatively competent at 106%. Our long-term debt at the end of the first quarter was $568 million, while adjusted debt including leases with approximately $4.5 billion. Our outstanding 2013 senior notes are rated investment grade by both Moody's and Standard and Poor's. Our capital structure strategy has been to achieve a solid investment grade credit to access commercial paper market and to lower our overall cost to capital. Our Board remains committed to maintaining flexibility in our balance sheet. Return on invested capital for the trailing fourth quarter adjusted for charges increased to 16.1% from 13.3% in the prior year. Our return on equity adjusted for charges in credits for the trailing fourth quarter improved by 690 basis points to 23% as compared to 16.1% for the previous four quarter periods. As a reminder, we continue to review our internal financial reporting measures and may modify our external disclosures as appropriate. For example, we continue to evaluate the merits of representing distribution costs as a component of cost of sales. That concludes my remarks and now I would like to turn the call back over to Steve.

[Steve Odland:]

Thanks Pat. Shifting to the future, I will remind you that we have three key strategic growth priorities, first is North American Retail. We want to continue to improve store productivity and have accelerated our store expansion remodel plans. We are in the process of substantially refreshing our chain over the next two years. We opened 16 new retail stores during the quarter with plans to open about 150 this year. Second is North American Business Solutions. We plan on profitably growing our market shares through new customer acquisitions and new product and service offerings supplemented with available tuck-in acquisitions. We've not only grown our sales force, but we've devoted more of our existing sales resources to customer acquisition. We have expanded our outbound sales and customer retention calls with our Telephone Account Management group and we have supplemented growth with a recent acquisition in Northeast. We've also introduced robust technical services offering for our small business customers. We will lap the merger of brands in our catalog business by quarter three and the investments made since the quarter four of 2006. So margin recovery from recent investments in this division will be expected in the second half of this year. And finally international our third strategic growth priority, we want to continue the progress that we have made in profitable market share growth in Europe and continue to increase our geographic reach. Our management team in Europe is making great progress achieving a fifth consecutive quarter of growth in improving. Our new management team in Asia has established a sourcing office that allows to globally source a greater percentage of our private brand. We still need to complete a few of our restructuring initiatives in Europe and to realize these synergies from acquisitions made over the course of the year. We have a business that generates substantial cash flow, year in and year out. We can use our cash to profitably grow our business by opening new stores in new geographical markets, by making necessary investment in the core business like store remodels, and distribution facilities, by acquiring assets or businesses in our key priority areas, and then finally repurchasing stock. While a launch of the Vista operating system in the general business softening created a challenging condition in the first quarter, w are pleased that still we were able to deliver EPS growth of 25%. Remember though that the second quarter that we are in right now is our seasonally lowest sales quarter and will be difficult to show cost leverage as the small business spending remain soft. But we are very pleased with the progress that we have made to-date relative to our growth in cost management initiatives and remain excited and confident about the long term opportunities that lie ahead of us. While no company is completely immune from the effects of external events, we have established an environment here that ensures that our team has every incentive to optimize results for our customers, employees and shareholders overtime. And built a strong track record of delivering winning solutions, both within the organization and to our external stake holders and we believe that the initiatives that we have described will yield profitable growth over the long-term. Now I would like to open up the call for questions.

[Operator:]

Thank you, sir. (Operator Instructions). Our first question comes from Matthew Fassler. Sir, your line is open.

[Matthew Fassler:]

Thanks so much, and good morning.

[Steve Odland:]

Good morning.

[Matthew Fassler:]

I would like to ask two quick questions. The first relates to international, you discussed in the release and on the call, the pressure on international EBIT margin from acquisitions that you didn't own in the prior period. I think all of these acquisitions were part of Office Depot in the first quarter as well. Did they exert pressure on a year-to-year basis in Q4 that we just didn't see, because of better organic growth? I'm just trying to get an understanding of when they began to have a detrimental impact on margin on a year-to-year basis?

[Pat McKay:]

Yeah Matt, this is Pat McKay. We had about pretty consistent influence on the acquisitions, perhaps a little bit more because we started to invest in developing some of the synergies in Q1 that we had not done in Q4. And in addition to that, we made a number of investments as we have talked before Matt, one of things that we do, like in our Business Solutions Division and international, our investment in that business actually occurs in the form of expenses.

[Matthew Fassler:]

Right.

[Pat McKay:]

It was about 30 basis points in Q1 as well in our base business, the investment spending to be able to drive future performance. So as a combination of two factors are some of the things that you saw influence the Q1 operating margin.

[Matthew Fassler:]

And to the extent that you disclosed that organic apples-to-apples, international businesses were up 50 basis points in terms of the EBIT margin in the first quarter. How does that compare to the fourth quarter trend?

[Pat McKay:]

Again, if you included the effect of the investment spending, you would see about a similar type of increase in Q1, perhaps a little bit moderated.

[Matthew Fassler:]

Got you. Second question, if you could talk to the softening in demand that you seem to see in North America, and whether it impacted your core supplies business. You talked about technology in terms of Vista; you talked about furniture in terms of the macro or demand slowdown. What did you see in supplies during the quarter and did that moderate as well late in the period as you saw this demand issue?

[Chuck Rubin:]

Matt, good morning, this is Chuck. The supplies business was soft and did moderate as we came back in the quarter. Keep in mind, we had spend a lot of time over the past couple of years building on our efforts in the stores on building a market basket and selling a solution. So as we saw at the beginning of the quarter that the slowdown due to the PC and laptop issue, that trickled over to other issues, but kept it moderate as we got back into the computer business. The reason that we feel confident about the long-term future is that overall those efforts in the stores to sell that basket, to sell something in addition to a computer, and that includes core supplies, really has taken good traction and we feel good about it as we look out.

[Matthew Fassler:]

Got you, but if you would take a look at things like writing equipment and paper and things like that, did that experience some of the challenges that you talked to late in the period?

[Chuck Rubin:]

You know Matt, I think when we are out of computers, store traffic is hit all over. So I think the supplies business is strong. The issue is that in January we just went out of business. I think going forward, as we look at this though, if the estimates are that 75% of the world's supply of computers are going to have to be replaced in order to effectively run the Windows Vista Operating System. Now, the question is when is that going to kick in here and I don't think it's going to happen next week. But I think in the next few quarters people are going to have to start to catch up here. So, that's what we saw early on. We recovered nicely after Vista, but across all the categories except really furniture, where the softening has been continuous over the past year.

[Matthew Fassler:]

Got you. Thank you very much.

[Operator:]

Our next question comes from Colin McGranahan. Your line is open sir.

[Colin McGranahan:]

Thank you. Good morning. Couple of questions. First, focusing on the BSD division, can you talk about the organic growth rate of the business excluding Allied, and possibly give some color on the difference in trends between contract organic growth ex-Allied and catalog and if you saw any change in the catalog business?

[Steve Odland:]

Yeah, the organic growth rate was 4% ex-Allied. The contract business was up very strong and again, we are continuing to [lap] the catalog consolidation. We should be lapped by the end of the second quarter and then, the second half of this year we're back to normal trends. But if you look at the catalog business linearly, after we consolidated the catalogs, we've had a pretty stable business there. So, therefore, we have pretty good confidence here that what we are seeing is just continuing the lap here. Again we are pleased with the results going forward in the catalog business. We are also pretty pleased with our organic contract business. The Allied thing was a first quarter issue, we had great success in the Allied consolidation up to that point, but the important thing to know is that the service issues are solved, and we are in the process of trying to hire sales people to fill the slots and so, we still have great confidence that that acquisition is going to be a positive one for us. It’s just going to take a couple of months to get that back on track here. But most of this was in the New York City area unfortunately. So, different elements of the contract businesses, as your question indicated here. But we are feeling pretty good about the second half of the year in BSD.

[Colin McGranahan:]

Okay. And then you said obviously the second quarter is the seasonally light quarter and expense leverages a lot tougher. And in the first quarter you showed G&A dollars actually down year-over-year. Is that a sustainable trend, see actually a natural reduction in G&A dollars?

[Steve Odland:]

We've seen, we've got hundreds of projects going on and a lot of people have asked us well, is it over and the answer is no. The cost savings efforts are not over. With hundreds of projects that we think can continue to bear fruit overtime. Now some of those are longer term projects, some of those are short, some of those we've had to make capital investments to get the cost savings and so forth. So, we think that the SG&A savings is something that we are going to continue to see. Now the problem with the second quarter is that particularly in the BSD business that the expenses and the cost structure in BSD are relatively structured, rather than the retail business, where you can flex hours out along with sales, so you get more of a variability and you have more levers to pulling that business to gear the cost structure towards whatever you are experiencing. BSD needs volume to leverage it and given the seasonally slow period this happens. This is the seasonally slow period, every year it's been going on forever. It's going to be tough to see it which is why we are saying that the margins in BSD for the second quarter should be down versus year ago about the same amount they were down in the first quarter, and that margin recovery should happen in the third and the fourth quarter. And we feel pretty confident about that happening.

[Colin McGranahan:]

Okay. And then just finally a couple of housekeeping items, can you tell us what the $12 million charge was? And then Chuck, you quantified the impact of cannibalization private label rebates in furniture, but actually you didn't quantify Vista, but I know it's a little bit tricky because of the issue that traffic is generated by the PC category. But do you have any sense of how much that Vista hit your comps in the first quarter?

[Pat McKay:]

The Vista comps as we see it actually, I will give you the number and then Chuck will embellish on a little bit, but impacted our comps by about 200 basis points in the first quarter, and Chuck, if you want to talk a little bit further about that?

[Chuck Rubin:]

Yeah Colin, adding to Pat's point, it was about 200 basis points. It was a combination of the actual hardware and all the peripherals that went with that that really dragged it down.

[Colin McGranahan:]

Okay, and then the $12 million charge?

[Pat McKay:]

And then on the $12 million charge, what that includes is a number of things that we have been talking about in our disclosures, etcetera. The number of the consolidation efforts that we have been doing in Europe, as well as some of the continued efforts here in the United States and some of the network and the supply chain consolidation efforts are what's being reflected in those charges.

[Colin McGranahan:]

Okay, thank you.

[Operator:]

Our next quarter comes from Gary Balter. Your line is open.

[Gary Balter- Credit Suisse First Boston:]

Thank you. A couple of follow-ups really on Matt's earlier question, just to understand. On the international, you mentioned that some of these acquisitions cost some money, but I think some of those were there in the fourth quarter as well. So I am just trying to understand the difference between the Q4 result and the Q1 result?

[Pat McKay:]

Yeah, Gary, one of the things that we will do as we take on acquisitions, we will identifies areas just like in restaurant business were its appropriate to make sure we make continued investments to be able to drive performance. So, for example, we mentioned on the call that one of the things that we are doing like in the US and like in Europe, etcetera, is expanding our sales force. But, the influence for example, of expanding sales force for doing other kinds of things that help us to develop the business overtime has short-term degradation on those overall margins of those newly acquired acquisitions. Again, long term will end up bearing fruits. So those are the kinds of things that we would be seeing happening in the first quarter, that weren't there in Q4.

[Gary Balter- Credit Suisse First Boston:]

Okay, so it's not the actual company operating results, it's your decision to reinvest back into (inaudible), is the way think we should think about it?

[Pat McKay:]

Yeah.

[Steve Odland:]

Yeah, it's really two things Gary. If you think about the base business, the margins have expanded on the base business pretty consistently between the two quarters. The issue is then you've got the mix hit from the acquisitions. Remember the acquisition were not dilutive, but they were lower margined, and so you got that mixing in, but at the same time, we think we mentioned that we are doubling the sales force in China as an example. We have opened six stores in Asia and so, we are trying to invest early on, which was planed again, and that is what is causing a little bit more of the impact from the acquisition. But we were very pleased with the results of the acquisitions and the growth that we are getting. Actually they are little ahead of the growth, is a little ahead of our pro forma.

[Gary Balter- Credit Suisse First Boston:]

Thanks. And on the core business, you talked about Vista hitting 200 and gave us some other reasons earlier in the call. Just to be clear, other than specific impact, where you saw customer traffic down because of Vista, office supply sales, sounded like they stayed relatively consistent? So that's when you are referring to weakness in the business, you are not referring to that core business, its furniture and computers. Is that the way we should read this?

[Steve Odland:]

Well, the Vista impact, we were out of business essentially in computers in January. That hit our store traffic entirely and so it hit the whole market now in the whole field.

[Gary Balter- Credit Suisse First Boston:]

Right.

[Steve Odland:]

So, yes that hit the core business, as strange as it sounds. Because computers are so important to our traffic in our overall business and building the basket, it hit the whole business. So, that's one way to think about it. If you bucket the impact of Vista with the traffic and the impact of the rest of the store, the core business this is relatively healthy after that. Obviously, furniture continues to be an issue, we are the largest office furniture supplier here in the country and that ties very strongly to small office and home office.

[Gary Balter- Credit Suisse First Boston:]

So, the comment from the press release later in the quarter by softening and spending by small business customer, is that referring to furniture?

[Steve Odland:]

Its furniture, but it's also the BSD. We just didn't see a lift in the back part of the quarter we had hoped following Vista.

[Gary Balter- Credit Suisse First Boston:]

Okay, thank you very much.

[Steve Odland:]

Part of that Gary is Vista too. People are waiting on Vista and so some of the softening we see is just people are holding back until they perceive that Vista is ready for primetime.

[Gary Balter- Credit Suisse First Boston:]

Which could be like 4 or 5 years?

[Steve Odland:]

I am not going to live that long Gary.

[Gary Balter- Credit Suisse First Boston:]

Okay, thank you.

[Operator:]

The next question comes from Dan Binder.

[Dan Binder:]

Hi, it is Binder, a couple of questions for you. First, one on housekeeping items, can you give us the organic growth for international and local currency, I think you said it was up 11 total local currency, what it would be your exact number looks like?

[Pat McKay:]

Yeah, the organic growth would be about 3%.

[Dan Binder:]

3%, okay. Secondly, there was a line item in your P&L amortization of deferred gain, I think on the sale of a building, is that number included in the $0.60 or included in the charges or net charges?

[Pat McKay:]

Yeah, that's included in the $0.60, so if you think about it, it is just some of the accounting nuances, but just taking, we did a sale lease pack and there is a gain on the sale of this building and that's really effectively part of the net operating cost.

[Dan Binder:]

Are we going to see that line item going forward for some period of time?

[Pat McKay:]

Just for the couple of years as we are still on this our existing corporate offices and then that will go away as we move.

[Dan Binder:]

Okay.

[Pat McKay:]

Two years.

[Dan Binder:]

And then on the contract growth rate, of plus 10% in the quarter, as I recall, and maybe I am mistaken on this, but I think the contract growth rate last quarter was close to 20%, if that is correct, it would seem that the large business spending may be slowing in addition to small and medium, is that accurate?

[Steve Odland:]

Well, our contract business had some of the Fortune 500 in it, but our business would actually skew a little smaller than most. We have a lot of medium sized businesses in it. We saw some softening on the small sized predominantly, a question of small and medium being in the contract side.

[Dan Binder:]

Okay, and then on the cannibalization issue that you raised during the calls, in your formal remarks, I think you said about 50 basis points from new store builds. As the growth rate of stores accelerates, what would you expect that cannibalization to -- see over the next, [1 to 8] quarters?

[Steve Odland:]

That will increase just a little bit. There seems to be some misunderstanding out there. We had some questions and heard some comments that people think that our new store productivity is not as high as it used to be in and that just simply is not the case. These new stores are producing very well and that's why we try to provide a little more color on that. We are very pleased with the results and what we do is when we do in field markets like these, we take the entire market into account, including cannibalization. And with the new stores as well as including in the cannibalization from the existing stores, they are hurdling our 13% IRR hurdles and are very productive. So, these are the right financial decisions to be making in the marketplace and frankly, if we don't do it, our competitors would do it. So that's make it even that much more accretive to us. So as we expand, it's about 50 basis points this quarter. It will be a little bit more than that in future quarters.

[Dan Binder:]

With the comp benefits and being open Easter Day, is that they are meaningful at all?

[Steve Odland:]

We only opened a couple of hours and we weren’t open in every store, so it helped a little bit.

[Dan Binder:]

And then my final question, in terms of pricing of retail, when you look at your pricing versus the competition, it looks like you finished up a little over last several quarters, do you feel like it is -- do you feel like it is you maybe gone a little too far ahead, is there anything that you would try to do, the softness in comps to that?

[Chuck Rubin:]

Dan, this is Chuck. We have talked many times before about our category management approach. We apply that approach to our pricing and we watch the marketplace in total as we've talked before. It's a very diversified marketplace, a lot of people selling what we sell. So, we are very conscious of our pricing. We still feel very good about it and we are competitive on all the critical products that we need to be.

[Dan Binder:]

Okay. Great, thank you.

[Steve Odland:]

Next question.

[Operator:]

Bill Sims, your line is open.

[Bill Sims:]

Thank you. Good morning, Steve, a follow-up to the Vista question your comments earlier, given the sluggish response, consumers are have to Vista and keeping in mind that yourself have improved since January. First, is there any risk, the markdown risk we should forecast in the quarter, if we don't see any real pickup in Vista, which people are expecting? And then two, alternatively is there any discussion internally to try to bring back XP enabled machines to drive the traffic until we do get that pickup in Vista demand?

[Steve Odland:]

Well, no there is no markdown risk, because we just don't have that much inventory. The issue is in our case; remember the vast majority of our businesses is small and medium sizes businesses, right. Even in the stores, 2/3rds of our businesses is the small business customers. So this is not a consumer issue; it is a small businesses issue. Converting a small business is a decision that everybody is going to wait until they have to do this, but when they do it, it is going too quickly. I think, it is going to start quickly, because you have to then start converting whole offices. You can't just do it one machine at a time. So, I think that by the end of the year, Vista sales are going to pick up. There isn't going to be any XP according to Microsoft back in the market place and so, they are not going to sell it, so we can't sell it.

[Bill Sims:]

Right. I just recently saw one of the large direct sellers of computers announced they would start selling XP machines again after very strong feedback from their customer's demanding XP. Until, some of (inaudible) but that could be more of a consumer-customer rather than small business customer.

[Steve Odland:]

It is a consumer-customer. I can't imagine any business customer wanting to continue to do that because that would just set him. You amortize those machines over in the software were 3 years and so. It would just start the amortization cycle. And it would them really. I think people are just running up the amortization on the machines and will convert it if that happens. Lots of these things are leased and the software is tied to the hardware.

[Bill Sims:]

Okay, very good. Thank you.

[Operator:]

Danielle Fox, your line is open.

[Danielle Fox:]

Thanks good morning. I have two questions. First, you Chuck, your comments on new store economics were very helpful. I think you mentioned the 67% new store productivity target. Could you talk a little bit more about how they ramp up, particularly given the fill-in strategy? Should we expect these stores to be accretive to comps in year two and three, as they go from 67% of existing sales per square foot closer to 100%?

[Chuck Rubin:]

Yeah, Danielle, I am glad you ask because this is really important for people to understand because we are investing more capital in the stores. But frankly, if these stores did not hurdle, we wouldn't be investing any capital in new stores, but we are very pleased with the investment. And so what we see is, about two-thirds of their total productivity happening in the first quarter, and that as everybody knows, doesn't count in the comp. So we see comp improvements in, or contribution in years two, three, four and a little bit in years five. And so you see that over the course of time, but net-net, even when we open up our stores in our existing markets, what we do is we take formula that takes all the attrition from the surrounding stores add that in that new store model, and we deduct that. And what we are seeing is that new store deducting all of the attrition still drives a hurdle above our 13% hurdle rate. So these are really good economic decisions for our capital. Now, if we see diminishing, which we have not for the last two to three years, if we see that diminishing, we will back-off and not open the stores.

[Danielle Fox:]

It's like I said, very helpful. Second thing is can you talk a little bit about the outlook for gross margin? Because it's kind of bounced around a little bit here over the quarter, and there were some one-time items or there was sort of an extra week that you are lapping in the fourth quarter. And then, I don't know if that had any impact. But, should we expect gross margins to be up, down, flattish for the rest of the year? And if you can't provide that level of details, just to think about some of the things that might change over the course of the next few quarters? Thank you.

[Steve Odland:]

Well, you are right that some gross margins do bounce a little bit, because we have different mix and different seasonality and so forth. Remember, the first quarter is back to business period, second quarter is typically our softest quarter. Third quarter we got back to school which is our heaviest consumer period. And fourth quarter is a pretty good quarter from the business standing. So, that mix contributes across the company at various points in time. Also, we have been diminished by our catalog business lapping. And that catalog business, the direct business has good margin. And so, we have mixed down as a result of that. As we lap that in getting to the third and fourth quarter, you should see the margin change come back. So, we believe that our gross margins and our operating margins can continue to expand over time. We believe that because we have been able to leverage our incremental sales, even with the acquisitions. We believe that because we have got hundreds of projects going on right now, which are driving cost savings and are producing cash for us. And also, we are working category management very strongly. We think there's pricing upside over time. We have been hit with paper pricing as we talked about in the past and that has diminished our margins, particularly in contract, where we are hung out on a few paper contracts. But we are revising as many contracts as possible to flow the paper and so forth. And then finally, we've got private brand penetration and that we've now opened up our sourcing offices and as those ramp up, we ought to be able to contribute to the margins through our higher private brand efforts.

[Danielle Fox:]

Thank you.

[Steve Odland:]

Thank you.

[Operator:]

The next question comes from Steve Chick. Your line is open.

[Stephen Chick:]

Hi. Thanks. And I guess Pat, just a simple question on your cash flow statement. In your investing section, you have a line of proceeds for disposition of assets and debt's return and so forth. What exactly is some of the activity there and does that have any P&L implications?

[Pat McKay:]

No. We have done some resources by decision. So, we've just had a shifting in terms of how we are going to be able to finance from our CapEx.

[Stephen Chick:]

Okay. So, there's no kind of disposal of assets and gains that's in the P&L?

[Pat McKay:]

No.

[Stephen Chick:]

Okay. And then with acquisitions and payments for acquisitions, are these earn-outs or payments that you've made for acquisitions that you made previously or did you actually [coordinate across masses] during the quarter?

[Pat McKay:]

That was an earn-out payment.

[Stephen Chick:]

Okay. Do you have a sense where that and how much more earn out payments you make as the year goes on?

[Pat McKay:]

I think we are done or we should be done. So, there are some real small things that could happen in the future, but again very diminish relative to this.

[Stephen Chick:]

Okay. And last if I could. It looks like you guys kept your store development, 150 store targets intact and with the CapEx target being lowered a little bit. I am sorry, I guess, maybe I missed it, but were you coming in a little late on the CapEx spending?

[Steve Odland:]

Remember we had CapEx laid out for IT projects as well as supply chain. The biggest change was in our supply chain. We had planned the CapEx to purchase facilities and that those facilities were planned for the latter part of this year and in the next year, which is mostly why the CapEx ramped up. It's the most substantial piece of it. As we are coming off leases on our existing facilities, we have to replace those. So, the initial assumption was that we would own, buy and own those facilities. We are now finding that that's more difficult than we thought and that we are in fact planning to lease those facilities again. So, that has moderated into cash flow and so you are right. And I think we need to make sure everybody understands this. We brought our cash, our CapEx numbers down substantially as a result of this change in lease versus buy, as well as some moderation in spending. And so, the numbers are substantially different over the next few years. So, we said about 500 this year, 600 next year and then back to 500. So, this isn't a continual ramp, this is a period in time. But those will continue to move overtime as our plans change, we don't expect it to go up significantly from here but they could wiggle.

[Stephen Chick:]

Okay, great. Thanks. That's helpful.

[Operator:]

And the next question comes from Jack Murphy.

[Jack Murphy:]

Good morning.

[Steve Odland:]

Good morning.

[Jack Murphy:]

Couple of quick follow ups and then a question. First, Pat, could you just clarify in that 200 basis point impact you said from Vista, does that apply just to January? I know that’s the fourth quarter number, but is there really anything outside of January in that 200 basis point number?

[Chuck Rubin:]

Jack, this is Chuck. The 200 basis points is the quarterly impact that obviously was skewed to January, but we did see some higher returns post the Vista launch, we believe from early adopters who were unhappy with the experience or something about their purchase. So they certainly brought that machine back. But the 200 basis points is the overall quarterly impact.

[Jack Murphy:]

Okay. Another follow up is you talked a little bit about pricing. Could you talk about the competitive environment both on the delivery and the retail side in terms of what you are seeing? Have you seen any real change, given the pressure from some weak small business, home, office spending?

[Chuck Rubin:]

No. Generally the pricing environment has been pretty stable and ongoing. So, we haven't seen any significant changes there.

[Jack Murphy:]

And then just the last question on the BSD side of the business. Given the somewhat slower sales numbers, could you just remind us of how the sales force is compensated? How much of that is dependent upon just overall top line growth? And what impact, if any, that had on the P&L on both in terms of, how you think that might impact retention and turnover in the sales force?

[Steve Odland:]

Yeah. Our BSD sales force is a contract sales force. Remember, has been built, we have added a hundreds of people over the past year. They reach productivity, meaning they pay themselves out in 9 to 12 months. So, we are still lapping that part of that investment and as we said, we will continue to do so in the current quarter. And then we lap it into -- recover them and see greater productivities starting in the third quarter. They have base and bonus. The bonus is paid off of profitable growth, so sales, but also margin in that. And if the sales don't come in, that part of the bonus is diminished. But, look, we are very proud of our sales force and they are working very hard. The new people are very productive and we have very good retention and we intend to do so going forward. We run out of time. This concludes our conference call this morning and we would like to thank everybody for participating.

[Operator:]

And that concludes today's call. Please disconnect at this time.