Operator:
Good day ladies and gentlemen and welcome to the <b>Staples, Inc.</b> 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 Thank you so much
Ronald L. Sargent:
Thanks Michael.
Operator:
Thank you. Our next question host from Simeon Gutman of Morgan Stanley. Your line is now open.
Simeon Gutman:Morgan Stanley:
Hi everyone.
Ronald L. Sargent:
Hey Simeon.
Simeon Gutman:
How are you doing? So my first question it was mentioned turning back to earnings growth can we speak to it in terms of EBIT or EBITDA growth, is that going be positive eventually and in that same regard, to $300 million of cost savings over the next few years, is that to offset investment or is some of that going to flow to the bottom or I guess to EBIT or to the bottom line? bottomline?
Christine T. Komola:
So I'll take that question. The earnings growth will come. We haven't kind of definitively defined that yet because we don't want to give forward-looking guidance.
But we definitely think it will be towards on the bottom line. And I think the $300 million it's going to be a combination of things. Some of that will go to the shareholders on the bottom line, some of it will be used to invest in the business and we will be flexible and we do think earnings will grow just in normal course particularly on some of the contact businesses that you saw this quarter. So we will continue to drive the growth through the sales of those businesses as well as manage the $300 million opportunity that we've got.
Simeon Gutman:
Okay and then from a demand side, some of the categories or some of the categories you sell secular pressure can you talk about how that curve look today versus how it did a year ago? Is the curve steepening when you look at ink and toner and paper demand or is the rate of decline, is that holding steady?
Ronald L. Sargent:
No I think it's relatively steady when you look at office supplies were shrinking and now they are kind of flattish. So office supplies themselves are getting a little better. When you look at ink, toner, and paper, I think they have been down kind of 3% or 4% over the last few years and that's continuing on.
In terms of technology the technology particularly in retail that rate of decline is slowing. We are still very negative but not nearly as negative as it was a few years ago.
Simeon Gutman:
Okay my final question on the marketing expense; I think it helped across the board but in both two North America delivery and stores, how did come down? What type of spend came down and is there a residual hit from that in other words, is that not only an impact if you could see the near term from what's marketing but could there be some residual impact over the next couple quarters from it?
Christine T. Komola:
As we looked at the marketing expense, we've really been very scientific and use a lot more of the analytics capability that we have been to able build in house. So in general the merchants and the marketing people would always say you're gonna lose some sales and that's probably true but we think that we have enough offsetting opportunity with investing back in price on the online side of the house for example and investing in some of the sales force in the digital tools to the sales force team in the contracts business. So we have been very thoughtful about how we manage through the usage of that spend and really driving sales activities in a laser focused way versus kind of a generic brand focus that we've had in the past.
Simeon Gutman:
Okay. Thank you.
Ronald L. Sargent:
Thanks Simeon.
Operator:
Thank you. Our next question comes from Mike Baker of Deutsche Bank. Your line is now open.
Ronald L. Sargent:
Hey Mike.
Michael Baker:Deutsche Bank Securities:
Hi, how are you. I wanted to ask a couple of questions about that middle market opportunity. So can you help us by sizing what percent of your commercial business now would you consider middle markets and any commentary on what you think your share might be there and then the sort of fault is how this initiative we are talking about here will be different than in the past? You know I have been coming here for a long time and this isn't the first time we have heard about any middle market initiative so just wanted to flush that out. Thanks.
Ronald L. Sargent:
On the stat, its about 20% of our contract sales and I'll ask Shira Goodman who has been heavily involved in this.
Shira Goodman:President, North America Operations:
Yeah. So first of all mid market while it is primarily through Staples Business Advantage, it actually spreads across of the company and we have mid market customers who shop in stores, through Staples.com, Quill, and SPA and actually that's a lot of the opportunity which is how do we bring the different channels together and really have a convergence of course to go much more after. So from a North America perspective, it is closer to 10% or 15% of the total North American business and we are already today growing and gaining share in this market and the key on it is that these companies are large enough that they have more sophisticated needs and marketing facilities et cetera. But they're small enough that they don't actually have the sophistication or the scale out to have those in house.
So, we are seeing that the value proposition of product assortment, competitive pricing, very reliable delivery. Lastly, expertise that we bring is really enabling us to gain share both in the core but especially in the beyond office supply category.
Michael Baker:
And so any idea what that share is currently?
Shira Goodman:
So the share, just across the board our mid-market share is lower than it is for either small businesses or larger businesses because we invested more in the other ends of the spectrum and the core share is still very solid, the boss share is 1% to 2% is fairly de-minimis and it's a huge opportunity.
Michael Baker:
Okay, interesting. The follow-up question just on the Staples print business that you are divesting so you said it will be a 4% hit, what will due to the operating profit in the commercial business and will that be accounted for as in discontinued operations?
Christine T. Komola:
It will probably be negligible to the bottom line, because it does have a lot of capital, lot of intensity on the actual operations side of it. We don't expect a significant hit . I mean it will go into although we'll publicly sell it pretty quickly but it will flow through discontinued or unless it's just to complete sale in Q2?
Michael Baker:
Okay, thanks for the color.
Ronald L. Sargent:
Thanks Mike.
Operator:
Thank you. Our next question is from Matthew Fassler of Goldman Sachs. Your line is now open.
Ronald L. Sargent:
Good morning Matt.
Matthew Fassler:Goldman Sachs:
Thanks a lot. Thanks. Good morning guys. My first question, part of the prior but if you think about the decline both in marketing costs versus percent of sales and also the lower labor expenses for North American delivery and the nice margin expansion that you saw there without issuing guidance that you know you're reluctant to do, would you say that margin expansion is feasible there over the course of the year going forward with the kind of sales performance that you put up in Q1?
Christine T. Komola:
Hi Matt. It's Christine. Actually I think as you know we focus on dollar growth and the best kind of our emphasis.
Here having said that we've had kind of nice steady returns here and we expect that to continue throughout the year.
Matthew Fassler:
Okay so in other words the investment levels has gone in such of that with limited top line that you should be able to at least hold for profitability in to any day?
Christine T. Komola:
I think that's how we started this year and you know you see the return coming through on some of these investments.
Matthew Fassler:
Got it. Second question kind of strategically having just been through this very extended process and having gotten to know the competition I guess a bit better and may be a bit differently now that you have emerged from this process, any new perspectives you'd be willing to offer about where you all think you have particular competitor strengths and areas where you feel compelled to improve the business relative to competition.
Ronald L. Sargent:
Yes I think obviously I don't know if you are talking about Amazon business specifically but our views there haven't changed at all. We still think there are a very strong competitor in retail and Staples.com and in contract. We believe that to be successful in this industry we've got to be competitive on assortment, we got to be competitive on prices and delivery capabilities and I think our differentiation going forward not only against Amazon business but anybody is we are going to differentiate based on expertise that we can provide to mid-market as well as services that we can provide to mid-market.
I think we've got a lot of initiatives underway that zero in on that mid-market segment and at the same time I can tell you I think stores still provide a competitive advantage for us. People still want to shop in stores, online purchasing is still I think in this whole country is about 20% of retail and so 80% is still going on in stores. There may be too many stores out there and I would agree with that and I think there will be fewer stores going forward. But I think stores represent a competitive advantage.
I think our specialized focus on the office products and mid-market is going be competitive advantage versus others.
I think when you are buying as much products as we are buying, we should be able to buy very well in the industry. So there is a lot of competitive advantages I believe we have not only against traditional office products' players but also increasingly going forward against Amazon.
Matthew Fassler:
And then finally I know in your 10-Q you walked through some of the residual cash costs associated with the merger. I know that your store closing program has cash costs associated with it. As we think about free cash flow and model it out for 2016. Christine, what's the average dollar amount above and beyond your GAAP earnings and sort of traditional CapEx et cetera that we need to think about to get to a year-end cash number?
Christine T. Komola:
We've got about $100 million on average related to the restructuring and kind of the other costs that are unusual. We're not excluding the $250 million breakup fee so we think -- 600 million is probably the right number in the kind of ordinary course of business.
Matthew Fassler:
Got it. Thank you so much guys.
Ronald L. Sargent:
Thanks Mike.
Operator:
Thank you. Our next question comes from Chris Horvers of JP Morgan. Your line is now open.
Ronald L. Sargent:
Good morning, Chris.
Chris Horvers: JP Morgan:
Thanks. Good morning everybody. Wanted to follow up on that question so on a competitive advantage question this past year Depot has had a lot of challenges signing up new contract customers. Can you talk about your ability to maintain that edge and have we seen a lot of resumes from their sales force over the past year? Has delayed office max supply chain inspiration benefiting your business? How do you think you maintain this competitive gap over Depot going forward?
Ronald L. Sargent:
Shira?
Shira Goodman:
So we've actually looked at that gap over a couple of years and it has been pretty steady that our contract delivery business grow 600 to 800 basis points after than Office Depot. So I don't think it's a changing trend. When look at what's driving our growth, we've been steady on customer acquisition, we've been steady on customer retention and what's really driving that Staples Business Advantage growth is mid-market customers and categories beyond office supplies and neither those I think are really core to Office Depot's contract business.
Chris Horvers:
Understood and then so okay that's very helpful and then Ron can you talk about what your vision or how you think about the number of stores the right number of stores in North America or the United States for office products industry? You had some views in the past after going through this and seen how that business has transformed, how do you think about that going forward?
Ronald L. Sargent:
Well I think the customer's going to decide how many stores should be operating in United States and who is going to be owning those stores. I think in the past I quoted a number of something like 2400 stores and the office products industry in the US. I am not sure that's a bad number at all.
When you look at it today I think Office Depot operates may be 2000 stores may be a little less you look at Staples this morning I think we said that we are in the 1280 or 1300 range. So I think there are too many stores that are too close together I do and I think our opportunity is going to be to focus on the delivery business and kind of right size our store network but we won't be doing that alone. I think we will also look at competitive closings as well.
Chris Horvers:
So is the strategy you talked about I think 50 more store closures this year. So is the strategy two-fold way for the leases and at the same time see how aggressive Depot becomes?
Ronald L. Sargent:
I think the strategy is to kind of optimize our retail network in conjunction with other people trying to optimize their retail network. I mean you look at half of what is Depot stores are within five miles of a Staples store. You look at 70% to 80% of Office Depot stores they are within 10 miles of a Staples store.
So I think in terms of density, there's probably excluding the northeast, there is probably a density issue that probably has to be resolved as an industry not just by us.
Chris Horvers:
No. Makes sense. And then just follow up on the gross margin, I am not sure we covered this, the degradation year-over-year was actually most steep this quarter and than in prior quarters and it seems like it rolled over a bit last quarter. So what's driving because it doesn't sound like the mix is really changed tablets still being down a lot is that the pace of closures and the rent savings basically abating?
Christine T. Komola:
Chris, it is actually pretty much inline with what we expected. We did have significant improvements last year and this year's been a combination of the plan that we have within some areas to invest in some of our prices. It's definitely the deleverage of fixed overhead cost in our retail businesses in Europe and in the US but it's also products margin and rate improvement in the stores end-to-end the European stores as well, as we have been able to optimize some of those promotional offers that we've had.
So it is inline with our expectation and our planning strategy across the different business units. So I think that's a little bit what I would put the color around that.
Chris Horvers:
OKay. Thanks. So as we think about that going forward, does, do we annualize that or is the idea of investing price and drive sales and pick out cost to keep EBIT margin flattish?
Christine T. Komola:
It will vary by business units. So we are definitely focused on managing invested growing earnings so you will it on the bottom-line and some business unit we will invest more in price. Our strategy on price is to be focused on the business units where the units and the velocity can grow the most.
We are also very focused on making sure that the other line items within that gross margins including leveraging our supply chain is still an opportunity for us.
Chris Horvers:
Understood. Thanks very much.
Ronald L. Sargent:
Thank you, Chris.
Operator:
Thank you. Our next question comes from Kate McShane from Citi Research. Your line is now open.
Ronald L. Sargent:
Good morning, Kate.
Kate McShane:Citigroup Global Markets:
Hi.
Kate McShane:
Good morning. Thanks for taking my question. Just had one question about Europe. I know during the merger process that I think you were looking for interested buyers in the Office Depot piece of the European business.
I just wondered in terms of interest to the extent that you can talk about it, what kinds of interest that you did get and how will the dynamic change now that it seems like both European businesses are probably up for sale?
Ronald L. Sargent:
Christine?
Christine T. Komola:
So we were definitely working with the European Commission on the sale of the Office Depot business and there was interest. So I think that the office supply business over there is very fragmented. It's very disbursed across all areas so there was interest and I can't go into details around that at this point in time for our business for their business it's still too early but I think that the key point is, it is a fragmented market over there.
Our business is getting stronger and stronger with the leadership that is managed with John and his team so we'll see and keep you all updated as the process continues.
Kate McShane:
And how long are you willing to give the process again to the extent that you can discuss it before may be pursuing keeping Europe as part of the business and continuing to either re-strategize or reformulate the business there.
Christine T. Komola:
It's still early in our thinking and here's definitely a variety of ways to manage the alternatives that we've got. So I think it's still too early to put definitive timelines and specifics out there at this point.
Kate McShane:
Okay great. And then if I could ask an unrelated question to those two and it's been talked about a little bit already but with price investment, can you tell us how you're thinking about how much further you have to go, how much more work that needs to be done and ultimately do you think you have to be the lowest price in order to succeed or how you are balancing that?
Ronald L. Sargent:
Yeah. I think Kate it really relates to what segment of the business we're talking about. If you look at some of the largest companies of America I mean they are already buying very, very well.
When you look at our online business or our retail business, I think there are some items that are we are remain to high at. Online, couple of weeks ago we announced the very significant reductions in prices on ink and toner, which is the most price sensitive item or one of the most price sensitive items for our customers. So I think our goal is to get close to anybody out there in the price sensitive items. Not, saying you have to be the absolute lowest but I think you got to be within shouting distance and particularly when you think about some of the other things that retail offers, there are some advantages of retail that maybe customers don't quite expect due to the absolute lowest but the other things that retail offers are largely be, maybe slightly higher.
So, I think, we look at pricing like everybody else does. We look at price sensitive items, we look at the elasticity of those. We look at things that are kind of medium and then we look at things that are not elastic at all. But I think in general over the last three years, part of the investments that we have made as a result for the cost take out has been to lower prices and I think we still have a ways to go.
And then finally once you get into the contract area, you know you are negotiating prices item by item in terms of off contact or on contract and I am not sure there is a lot more to be done there because we're pretty aggressively pricing the contact side of our business already.
Kate McShane:
That's very helpful. Thank you.
Operator:
Thank you. Our next question comes from Greg Melich of Evercore ISI. Your line is I. Your line is now open.
Ronald L. Sargent:
Good morning, Greg.
Greg Melich: Evercore ISI:
Good morning. A couple of questions, I was really thinking about the longer term plan of getting the 80% from 60% in to the year commercial side of business if where you were the plan was 2400 stores for the office product industry what do you think is the reasonable number for you as you look out now?
Ronald L. Sargent:
Yes I am not going to get into that. I am not going to be sending out competitive messages about what we think our number is. We talked about closing 50 stores this year.
I think we talked a few years ago back closing 300 and I think with these 50, we'll be above that 300. We don't have a lot of stores that lose a lot of money and we are trying to make sure that our lease obligation is getting as low as possible so we do have flexibility going forward but in terms of our number of stores, we are not getting there.
Greg Melich:
Okay and I guess on the lease obligations I think the rent expense now is around $700 million, could you let us know how much of that is in North America versus Europe given that you are considering leaving that strategic options and also my guess is the European lease terms are longer than North America's is that true the average lease?
Ronald L. Sargent:
Yes the average lease is a little longer John. Just under five years in Europe right now is the average lease period and US is in the three years.
Greg Melich:
And of the rent expenses Europe higher on average per foot?
Ronald L. Sargent:
Yes per foot definitely.
Greg Melich:
And then the last on the other $300 million of cost reductions you guys have outlined, what cash cost would there be to executing on those?
Ronald L. Sargent:
What? I am sorry, what was that question again Greg?
Greg Melich:
What cash cost will there be if any to executing on the next $300 million cost reduction plan that you announced?
Christine T. Komola:
We haven't gone to that level of detail but I wouldn't expect it to be a significant change in that what we have done.
Greg Melich:
So the ratio will be similar to what we saw on the first plan.
Christine T. Komola:
Yes maybe and then probably a little bit less.
Greg Melich:
Okay. Fair enough. Good luck.
Ronald L. Sargent:
Thanks Greg.
Christine T. Komola:
Thank you.
Operator:
Thank you and our next question comes from Dan Binder of Jefferies. Your line is now open.
Ronald L. Sargent:
Good morning, Dan.
Dan Binder:Jefferies:
Good morning. Thank you. I just wanted to go back to the initiatives in terms of your mid-market. Obviously adding a thousand new sales people and focused on that part of the market is where the focus is on the independent channel and I was wondering if you could just give us sort of state of the industry update on the independents as you see it and whether you think its going to require this sheer brute force in terms of putting sales people out there or incremental price investment versus how you price that segment today?
Ronald L. Sargent:
Shira?
Shira Goodman:
So I think it is both offering to the customer and how we approach the customers. So it is expanding our products and services that we really can offer the full range of what they want continuing our competitive pricing as Ron said because we are competitive in this area and the delivery for mid-market actually omni has some value. They like to pick it up in store at times, same day shipping will leveraging our retail network as well as things like printing the same day satisfaction that is valuable to them. And then the secret sauce is really the expertise that we bring to the mid-market customers.
And that's where its a combination of our sales growth and yes, we will be adding a thousand sales people . So really combining them and empowering them with data and digital assets and its really in that mix that we think we can gain share very cost effectively and differentiate ourselves from the other competitors in the market.
Dan Binder:
Now that -- those independents have largely been successful with I would probably describe as fanatical customer service and Staples being a big organization has good customer service but I suspect some of the mom and pop businesses out there have these long term relationships with independents. So how do you overcome that? How do you really distinguish your service levels versus that mom and pop player?
Shira Goodman:
I think we distinguish our service levels with our execution of it and our supply chain is going strong and their service levels and by adding the sales people that does enable more of the one to one personal touch that sometimes it does take to differentiate from it and the final piece that I would add to it is that increasingly our customer base is changing as well and they are becoming more digitally astute. They are used to buying online and therefore our digital capabilities which are far out paced the independent fielders we see time and time again is really being a lever to grow their share.
Dan Binder:
That's great and if I could just follow up another question, well two actually, one could you just come on the cadence for the quarter. I know there is some retailers out there that has talked about slow downs in April. Some are attributing it to weather which would not affect you but some more macro type commentary so if you can comment ary so if you can comment on that and then the last one was just regarding these Boss categories you've obviously outlined some that you are pursuing today I'm just curious if there's any sort of new categories that you would be willing to share with us today that they are coming up on your radar.
Ronald L. Sargent:
Yeah. In terms of the cadence of the quarter I mean we are one of those lucky retailers that are February, March, April quarter so Easter is kind of typically always in our quarter sometimes it's late in the quarter sometimes early in the quarter. So in terms of the cadence we are affected by the Easter shift and it came back to us the following month.
In terms of Boss categories, Shira?
Shira Goodman:
I would say we have a very broad offering today when you think about everything from facilities to print, promo, text, furniture but one category that we're particularly exciting about and is leading the path and growth rates is rate growth. And that is obviously coffee as the core there but then everything that surrounds coffee including food and snacks et cetera and that's real growth area. Overall I think it's company's use breakroom as a way to attract talent and build culture and it's a real opportunity for us that's paying off.
Operator:
Thank you and our last question comes from the line of Anthony Chukumba of BB&T Capital Markets. Your line is now open.
Ronald L. Sargent:
Good morning, Anthony.
Anthony Chukumba:BB&T Capital Market:
Good morning and thanks for taking my question. I guess my first question, could you just give us a quick update in terms of sales trends for reits from closed stores?
Ronald L. Sargent:
Sure I mean I think only just give you a big picture but when we close a store, that's 70% affecting other stores and about 30% of time where we don't have any store anywhere close so there is no transfer there. When you look at the 70% where there is a transfer, it's roughly 20%. And I understand that Office Depot is getting a little higher transfer rate but my guess is the stores that they're closing would be Office Max Office Depot stores that are closer together.
So it runs around 20% for the stores where we do have competition if you put those 30% in that we don't have any stores close by we'd probably in the 15% to 17%.
Anthony Chukumba:
Got it. That's helpful. And then my last question was related to I guess this new Labor Department regulation where they are increasing the threshold of first of salary for I guess employees that are eligible for overtime. And I guess I'm just wondering and maybe it's too early but I mean first off do you see this having an impact at all to your North American retail stores and what steps can you take to sort of you know offset that?
Ronald L. Sargent:
Yes I mean obviously it's very early day so we haven't done any math but I can tell that we were kind of very early on this one because we operate a lot of stores in California and you know several years ago we reclassified some of those assistant managers to hourly just because of this issue. So I think we're pretty far ahead on the issue most of our managers work our system managers are kind of working similar to kind of our store managers we don't have a lot of 80-hour a week manager types like you might have heard about in some of the press.
Anthony Chukumba:
Got it. Thank you for asking my question. It's helpful
Ronald L. Sargent:
Thanks Anthony.
Operator:
Thank you and I'd now like to turn the call over to Mr. Ron Sargent for any closing remarks.
Ronald L. Sargent:
I'll just wrap up by saying thanks for joining us on the call this morning. We look forward to speaking to all of you again very soon.
Operator:
Ladies and gentlemen, thank you for your participation on today's conference. This concludes your program. You may now disconnect. Everyone have great day.
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