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Staples Q1'16 Earnings Conference Call: Full Transcript

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Operator:

Good day ladies and gentlemen and welcome to the <b>Staples, Inc.</b> (NASDAQ: SPLS) First Quarter 2016 Earnings Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. If anyone should require assistance during the conference, please press star then zero on your touch tone telephone. As a reminder, this conference is being recorded. I'd like to introduce your host for today's conference Mr. Chris Powers, Vice President, Investor Relations. Sir, you may begin. 

 

Chris Powers: Investor Relations:

Thanks. Good morning everyone and thanks for joining us for our First Quarter 2016 Earnings Call. During today's call, we will discuss certain non-GAAP metrics. Please see the financial measures and other data section of the Investor Information Portion at staples.com for a reconciliation of these measures. 

Certain information we will discuss constitutes forward-looking statements for purposes of the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by such forward-looking statements as a result of various factors including those discussed or referenced in Staples' 10-Q filed this morning. 

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

 

Ronald L. Sargent:Chairman and Chief Executive Officer:

Thanks Chris and good morning everybody. Thanks for joining us today. This morning we announced our first quarter results that were right in line with our expectations. 

Before I discuss Q1 in more detail, I'd like to start off by covering some recent headlines relating to two topics. One is our attempted acquisition of Office Depot and two is our strategic plan going forward. 

I think everybody on the call knows that last week the US District Court for District of Columbia granted the FTC's request to block our acquisition of Office Depot. We were disappointed that the FTC's request was granted despite the fact that in our view, it failed to define the relevant market correctly and failed short of proving its case. The FTC excluded ink and toner from the market definition of consumable office supplies. They are only focused on Fortune-100 customers and acknowledge that there were no concerns about any harm to consumers or small or medium businesses. 

The FTC ignored the competitive threat from Amazon business and a host of other competitors and also encouraged witnesses to say things that weren't true to bolster their case. We are also disappointed that our proposed remedies to satisfy the FTC's concerns were unsuccessful and that our commitment to invest a significant portion of the synergies and lower prices for all customers was not heard. 

We'd pursue the Office Depot acquisition to provide increased value customers, to compete more effectively against the large and diverse set of competitors, and to generate tremendous value for our shareholders. Over the past 20 months, we've committed a lot of time and resources to getting the deal done. Given the additional time and resources we'd have to commit to pursue an appeal, we have determined that it is in the best interest of our shareholders to forgo appealing the court's ruling. 

Earlier this week we terminated the merger agreement with Office Depot and we will pay the $250 million breakup fee tomorrow. Our divestiture agreement with Ascendant also terminated in connection with the termination of the Office Depot merger agreement and finally I'd just like to thank both Office Depot and Ascendant for their hard work and for their collaboration as we pursued this transaction.

We are now focused on moving forward and we are focused on executing our strategic plans to drive shareholder value or what we are referring to internally a Staples 2020. This plan builds on our reinvention successes over the past few years and is supported by our strongest competitive advantages. We've had good success driving growth in categories beyond office supplies and in growing our mid-market contract business. We have also been challenged by weak results in Europe and in North American stores. 

We are confident that by narrowing our focus we're aggressively pursuing our best opportunities, accelerating growth on our asset-like businesses and pulling back in areas with less potential, we can get back to sustainable long term sales and earnings growth and significantly improve return our net assets. 

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

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

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

Let me take a few minutes to give you a little more color on each our four priorities. 

First; winning with mid-market customers in North America. We define the mid-market as business customers with 10 to 200 employees. This is our highly profitable and highly fragmented customer segments and today we have very low share with mid-market customers in categories beyond office supplies. The needs of those mid-market customers align closely with our strengths. 

These customers need a wide assortment of products and services, a support of category specialist who have expertise and easy online shopping experience as well as quick and reliable delivery. 

We have expertise on a wide range of products and services. We have a world class supply chain and next day delivery capability. Our digital expertise provides a differentiated customer experience. We have a new mid-market loyalty program that is driving increased spends, high retention rates and increased customer engagements and we recently re-branded our B2B division Staples Business Advantage to emphasize the many advantages that we can provide to those business customers. 

To accelerate growth in the mid-market, we have developed a strong customer-focused plan that builds on these strengths. Our plan focuses on increasing our share of wallet with the hundreds of thousands of mid-market customers we serve today and on acquiring many of the mid-market customers that we don't currently serve. We're increasing our offering of products and services beyond office supplies and pursuing market share gains in core categories like office supplies, ink, toner, and paper. We are investing in sharper pricing and enhanced supply chain capabilities. 

We are dramatically expanding the size for our mid-market salesforce with the addition of more than 1000 new sales reps and we are also pursuing acquisitions of B2B service providers in companies specializing in categories beyond office supplies. 

In summary we are helping smaller and mid-market customers compete like a Fortune-500 company. 

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

As a result we've decided to explore strategic alternatives for our European operations. Over the coming weeks we plan to meet with potential buyers of our European operations and we will provide more details on timing and valuation as we work through this process. We also remain committed to increasing productivity and preserving profitability in our North American retail stores. We have closed more than 300 stores and reduced our leased obligations by more than a billion dollars in North America since 2011. 

We have also aggressively managed our lease renewal process. Today, our average remaining lease life in North America is about 3.5 years per store. That's a reduction of more than 40% since 2011. 

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

In addition to closing unproductive stores, we will continue to build on the strength our omnichannel capabilities in services like copy and print. We believe our store provide convenience and immediacy that is valued by customers of all sizes including mid-market customers. 

Our third priority is to aggressively reduce cost across the company to drive efficiency and fund our growth investments. Over the past three years we have generated approximately $750 million of annual of annualized pretax cost savings by evolving the business processes, increasing productivity, and developing more efficient ways to serve customers. Last week we announced a new multi-year cost savings plan which is expected to generate an additional $300 million of annualized pretax cost savings by the end of 2018. We are focused on reducing product costs, optimizing promotions, increasing the mix of Staples brand products, and reducing operating expenses. 

We will also continue to reduce cost in retail stores as we right size our store network. 

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

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

Now let's turn to our first quarter results. 

Total company sales for Q1 were down about 1% year-over-year excluding the impact to store closures and changes in foreign exchange rates, non-GAAP operating income rates, and dollars improved versus Q1 of last year. Non-GAAP earnings per share of $0.17 was flat versus Q1 of last year. 

On our Q4 earnings call we talked about our key priorities for '16 which are now a critical part of our strategic plan. Let me take a few minutes to give you some color on our progress during the first quarter. 

One of our top priorities is to accelerate growth in categories beyond office supplies. Today nearly half of our sales are generated beyond office supplies and business customers are increasingly relying on Staples to provide them with a wider assortment of products and services. The market for these categories is highly fragmented and we are winning with business customers of all sizes by providing a differentiated level of service and expertise.

During Q1, North American contract continued to lead the way here with growth in promotional products, facility supplies, breakroom supplies, technology and furniture. We also grew key categories beyond office supplies and North American stores and online during Q1 with comparable sales growth in furniture, facility supplies, Copy & Print, Mail & Ship, and breakroom supplies.

Another priority is to grow our mid-market penetration in contract. During Q1 we grew North American contract sales by 2% in local currency. Our strongest momentum was in the mid-market where sales were up in the mid single-digits driven by sales beyond office suppliers which is up about 10% year-over-year.

Improved customer acquisition and retention offset modestly lower sales to existing customers and this was supported by additional mid-market sales reps that we hired during Q1 as well as continued strong performance in our mid-market membership program. We also noted our focus on our best growth opportunities in contract in the first quarter with the announcement our intention to sell our contract print manufacturing and operations business to Tailor Corporation. We acquired the contract print business when we bought Corporate Express in 2008. As we increase our focus on growing our asset like businesses and improving return on net assets, it made sense for us to part ways with contract print.

At Staples we lack the scale and manufacturing expertise that this business requires. 

The business is also very capital intensive, generates an operating margin below the house, and generates return on net assets below our cost of capital. While this business isn't a great feet in the Staples portfolio, it's a perfect fit for Tailor. We expect the deal to close during the second quarter. We look forward to continuing to offer a wide assortment of print solutions to our contract customers through vendor partnerships and our own in-store print capabilities. 

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

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

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

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

As I mentioned a few minutes ago, we continue to drive strong growth in categories beyond office supplies and contract during the first quarter. We achieved double-digit growth in promotional products and breakroom supplies and sales grew up in the high single-digits in facility supplies. Contract sales in core categories like ink and toner and paper were down in the low to mid single-digits and sales of office supplies were flat versus Q1 of 2015. During the first quarter, North American Commercial operating margin increased 63 basis points to 7% and operating income grew by approximately $14 million or about 10% year-over-year. 

This improvement primarily reflects lower labor cost and reduced marketing expense. 

We expect a divestiture of Staples print solutions to close over the coming weeks and as a result of the sale, we're planning for about 4% headwind to our reported North American Commercial sales and about 2% headwind to our reported total company sales over the next year. 

Turning to North American stores and online; sales declined approximately 2% excluding the negative impact of changes in foreign exchange rates and store closures. On a GAAP basis sales were down 5% to $2.2 billion versus Q1 of last year. During the first quarter combined North American stores and online comparable sales declined by 3%. This reflects a 1% local currency sales growth in Staple.com and a 4% decline in same-store sales. 

Results in Canada was stronger than the US in both stores and online during the first quarter. . 

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

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

During the quarter we closed 14 stores in the United States, ending Q1 with 1288 stores in the United States and 305 stores in Canada. We have now closed 256 stores or about 14% of the North American chain since 2014. 

Finally, turning to International Operations; our sales here decreased 3% excluding the negative impact of changes in foreign exchange rates. On a GAAP basis sales in US dollar were down 6% year-over-year, $738 million versus Q1 of last year. In Europe retail, same-store sales declined 9% during the first quarter driven primarily by a decrease in customer traffic versus Q1. In our contract business in Europe local currency sales were down in the high single-digit during the first quarter and our European online business, local currency sales were down in the low single-digits. 

Despite the weak sales trends in Europe during the first quarter , John Wilson and his team in Europe did a great job aggressively managing expenses and in fact drove improved profitability year-over-year. Outside of Europe, we continue to drive solid growth in China during Q1 with sales up in the strong double-digit range in local currency versus Q1 in last year. We also continued to make progress improving the bottom-line in Australia, New Zealand, as well as China. 

On the bottom-line, International operating margin rate improved 13 basis points versus Q1 of last year for an operating loss of 2.4% and this was driven by year-over-year improvement in Australia, China, and in Europe. And with that let me turn it over to Christine to review our financial results. 

 

Christine T. Komola: Chief Financial Officer:

Thanks John good morning everyone. Total company sales for the first quarter was $5.1 billion. On a non-GAAP basis total company sales declined 1% versus Q1 of last year. 

This excludes a 1% headwind from changes in foreign exchange rates and a 1% headwind from stores we closed in North America during the past year. 

On a GAAP basis, sales declined 3% versus Q1 of last year. During the first quarter, we achieved non-GAAP diluted earnings per share of $0.17 which was unchanged versus Q1 of last year. Our Q1 2016 non-GAAP diluted earnings per share excludes; pretax charges of $66 million primarily related to costs associated with the proposed acquisition of Office Depot and store closures. It also excludes a pretax charge of $32 million related to the pending sales of Staples print solution. 

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

During the first quarter, total company SG&A decreased $69 million year-over-year after excluding a $24 million charge in Q1 of this year primarily related to the proposed acquisition of Office Depot, (inaudible) million of acquisition related costs and $4 million of accelerated depreciation during Q1 of last year. This reflects lower labor cost due to headcount reduction and store closures, lower marketing expense, and the favorable impact of the stronger US dollar. As a percentage of sales, SG&A excluding charges, decreased 44 basis points to 21.5%. Excluding the impact of charges, non-GAAP total company operating margin rates increased 14 basis points year-over-year to 3.4%. 

Turning to our Q1 tax rate; excluding the impact of charges, our non-GAAP effective tax rate was 35.5% versus our non-GAAP effective tax rate of 33.5% in Q1 of 2015. This modest year-over-year increase in our affected tax rate was primarily driven by changes in our geographic mix of earnings versus 2015. Q1 capital expenditures came in at $44 million, a decrease of $16 million versus the prior year with operating cash flow of $276 million , we generated free cash flow of $232 million during the first quarter. 

During the first quarter, we did make cash payments of $69 million related to the Office Depot financing commitment fees earned by our lenders in 2015. If you exclude the negative impact of these payments, our first quarter free cash flow came in at $301 million. At the end of Q1, Staples had approximately $2 billion in liquidity including cash and cash equivalents of $946 million and available lines of credit of about $1.1 billion.

As Ron mentioned at the beginning of the call, one of our top priorities is to continue returning excess cash to shareholders. We returned more than 300 million to shareholders annually through cash dividends and we remain committed to our dividend programs. We also plan to resume share repurchases during Q2. Our current forecast is for about $100 million of share repurchases in 2016. 

As a result we plan to return approximately $400 million to shareholders this year through dividends and repurchases.

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

On the bottom line, we expect second quarter non-GAAP diluted earnings per share in the range of $0.11 to $0.13. 

Our earnings guidance excludes remaining costs associated with the proposed acquisition of Office Depot and the impact of ongoing store closures as well as the negative impact of the Office Depot breakup deal. We expect to generate approximately $600 million of free cash flow in 2016. Our free cash flow guidance excludes the impact of cash payments related to acquisition financing as well as the impact of the break up that we look pay Office Depot this week. In 2016, we plan to close at lest 50 retails stores in North America. 

Overtime our strategic plan will drive improvement in both the top line and the bottom line. We will experience sales pressure as we explore strategic alternatives in Europe and as we continue to close retail stores in North America. These headwinds will be offset by mid-market growth fueled by the categories beyond office supplies. We expect to get back to the same sustainable earnings growth as we restate Staples and resume our repurchase program. 

We also expect to free cash flow and a significant improvement in return our net assets as we increase our focus on assets-light businesses and reduce our exposure to our weakest performing businesses.

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

 

Question & Answer

 

 

Operator:

Thank you. Ladies and gentlemen, at this time if you would like to ask a question, please press star then one. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. And once again to ask a question please press star then one. 

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

 

Ronald L. Sargent:

Good morning, Michael.

 

Michael Lasser:UBS:

Good morning. Hey Ron. Good morning. Thanks for taking my question. 

So it seems like in the wake of the ODP situation, the strategy is now just to return to what where the areas of focus were in place prior to the deal and chip away at what you have been working on whether it's carrying cost growing categories beyond office supplies, how do you know that that's the right strategy or at least you are pursuing that strategy at the right pace. Why not make more aggressive actions in steps be the right path to pursue ?

 

Ronald L. Sargent:

The reason we're pursuing this is because we took a good hard look with a lot of inside and outside help of share of project for the last several months with some outside resources as well and we looked at kind of where do we compete best, where are our strongest competitors, we looked at not only today but also kind of down the road and basically it builds on some of the things that we've been very successful at over the last several years and whether that's you know kind of the opportunity of mid-market customers where we think there is a great opportunity to, one, get more of them as well as some more to them whether that's getting focus as more of a delivery asset-like company versus an asset-heavy company and talked about we are doing with retail stores and we have done with the retail stores and whether that talks about making a really a tough decision about looking at opportunities and options relating to our European business and I think in our situation in a declining industry, cost out is something we have to continue to do and we have done a pretty good job of that as well. 

So I think those are the elements of the strategy. I mean I'm sure anybody can say you're being too aggressive or not aggressive enough about particular part of the strategy but I think we are also in a competitive situation, we are also looking to see how our competitors respond going forward and we'll adjust and act appropriately going forward. 

 

Michael Lasser:

And my follow up question is I think we can have an easier view on where think ultimately your sales will level off judging by the performance of the various segments. What's harder for us to grasp is how significant are the pools of discretionary expenses that you are drawing that you could potentially reduce further from here and how do you balance reducing expenses with the needs for growth. You kind of a couple of years ago you listened a lot and you slowed the investment to train rather on return on investment. What's the strategy for you, how big is the bucket and where do you go from here?

 

Ronald L. Sargent:

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

 

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

So yes, it's a balancing act and the buckets of opportunity are large.

 

Michael Lasser:

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

 

Christine T. Komola:

It was actually a couple of things. One is the asset was partly mixed but it was also to the point of we have done a lot of hard work in looking at our promotional strategy. So getting more targeted on the types of promotions that we have out there and been able to move more of those dollars to everyday low prices in particularly online so we've been able to figure out how to really balance that type of marketing campaign and I would say that the US retail has done a lot to grow their services business overtime as well. 

So I think it's all of those things coming together and to Ron's point on the large pool, there are a lot of large pools and we do have a variety of ways that are starting to take hold that we'll be able to pursue even more aggressively.

 

Michael Lasser:

That's a very helpful commentary

Posted-In: Earnings News

 

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