Depot and ‘Max feeling the squeeze

 

After Office Depot’s July warning of "worse-than-expected" quarterly results (especially in the US retail sector) expectations were low for both its and rival OfficeMax’s second quarter results announced at the end of last week.

 

With Staples delaying its own quarterly results until the start of September due to the Corporate Express acquisition there is no immediate comparison with the largest – and strongest – player in the market. However, the financial markets are in no doubt as to the potential of the three companies: over the last three months Depot’s share price has tumbled by 48 percent, OfficeMax’s by 29 percent, while Staples’ has increased by a highly-respectable 7 percent, boosted by the potential synergies of the CE integration and its better profit margins.

 

So, how did the number two and number three players fare in the current difficult market conditions?

 

Retail blues

 

Depot and OfficeMax both reported a hefty 10 percent decline in the key same-store comp sales barometer.

 

Depot says that it saw sales decline in its major product categories of furniture, supplies and technology and that it is still feeling the effects of specific weaknesses in Florida and California which account for around 26 percent of its North American Retail (NAR) sales. However, it noted that economic weakness is now spreading to more areas of the country.

 

The division moved from an operating profit of $99 million (6.5 percent of sales) in Q2 2006 to an operating loss of $0.4 million, a swing of 6.8 percent, made up of de-leveraging of fixed costs (2.9 percent), lower product margins (2.2 percent) and inventory shrinkage due to "process issues" with direct import (1.7 percent).

 

OfficeMax reports its North American and international retail sales together, but North America accounts for around 94 percent of its total of $873 million.

 

Similar to its rival, OfficeMax saw sales drop in the three major product categories: technology, supplies (which includes ImPress sales) and furniture. The weakest comps were experienced for more discretionary items such as furniture and high-tech merchandise so average ticket values declined.

 

However, margins were helped by a greater ratio of higher margin supplies items versus lower margin technology products and overall operating margins stood at 2 percent, a decrease of 0.6 percent.

 

Both companies have said that they are slowing new store openings and store refits in an effort to reduce capital expenditure.

 

Depot says that it will open 15 more new stores during 2008 and a further 45 next year, admitting that due to lease commitments it will cost more not to open them, while OfficeMax says that a total of 40 new stores will open in 2008 and a similar number is thought to be planned for 2009.

 

Both Depot and OfficeMax say that they have no plans to implement store closures outside their regular review programmes.

 

Retail expected to worsen

 

The retail picture in the US is expected to get worse before it improves. Both Depot and OfficeMax have laid-off store workers in the last quarter and are mostly operating with minimum store staff levels. OfficeMax has cut 2,700 in-store management jobs and vowed to increase the number of people on the store floor to improve service levels. However, using more hourly-paid staff (which Depot is also doing), though cheaper, does not always translate into a better shopping experience for customers, and turnover rates are notoriously high, so this is a gamble.

 

As consumers and small businesses continue to cut back on spending, promotions are being used to try and drive in-store traffic, as seen during this year’s back-to-school period in the US. Playing the price card is pitching the office suppliers (and this includes Staples) against multiple retailers such as Wal-Mart and Target, natural choices for the price-conscious consumer.

 

Again, another gamble from the office suppliers who have said that they will not sacrifice margin, but it’s difficult to see how they cannot.

 

The key differentiator could be in online sales as the internet shopping base continues to expand. Staples is way ahead with 8 percent conversion rates, Depot comes next with 4 percent, while OfficeMax trails in third with 2 percent. It will be interesting to see if OfficeMax’s ‘Power to the Penny’ marketing campaign pays dividends, but evidence on parents’ and teachers’ websites and blogs suggests that consumers are actively shopping around the for the best deals.

 

Contracting contracts

 

The contract business is really key for OfficeMax as it accounts for almost 60 percent of its total sales.

 

US contract revenues, which represent about 70 percent of total contract sales, fell heavily by almost 13 percent compared to the same quarter last year.

 

While Max says that part of this was due to exiting an unprofitable contract at the end of July 2007, sales from existing customers fell by 6 percent and catalogue and online sales to smaller businesses also fell.

 

Contract gross margins increased slightly to 21.7 percent in the second quarter as better account management and delivery efficiencies were partly offset by higher fuel prices.

 

Cost reductions have also been achieved by the closure of three fulfilment centres in 2008 and the integration of the ImPress field sales team within the US contract sales team.

 

With quarterly sales of $1.1 billion, Office Depot’s North American Business Solutions Division (BSD) represents 28 percent of the company’s total sales.

 

During the second quarter sales fell by around 5 percent – this was due to a 10 percent drop in sales to small and medium businesses, while sales to large national accounts and the public sector actually posted a slight increase.

 

Depot says that around 40 percent of the total decrease was due to the California and Florida markets which make up 30 percent of BSD’s sales.

 

Outside of these two states a large portion of the sales decrease was in the Tech Depot unit, where Depot says it deliberately exited a number of unprofitable accounts.

 

Gross margins for the division slipped by 35 percent to 4.6 percent of sales, below the company’s own expectations, hit by lower product margins, fixed cost de-leveraging and reduced vendor rebates.

 

OPI verdict

 

Both Depot and OfficeMax are taking steps to turn around performance in their contract divisions, but the departure of numerous sales staff over recent months may be having a greater impact than either would care to admit and it seems clear that they are both losing market share.

 

Question marks still hang over Depot’s 21 state-wide contracts, notably in California, and we have had no feedback on contract reviews which were reportedly taking place at the end of the first quarter. The relationship with US Communities, despite an audit which took place at the beginning of the year, also requires more clarification.

 

More worryingly, the Staples/Corporate Express integration is looming on the horizon and once this machine is fully operational it’s going to become a formidable opponent.

 

Joining forces?

 

Steve Odland said last week that he was favourable to industry consolidation – presumably a tie-up between Depot and OfficeMax – and that he expected that this would happen "over time".

 

Both companies have their own internal problems to deal with and the consensus is that now is not the best time.

 

But with no short-term prospects for an economic revival, and main rival Staples dealing with its Corporate Express acquisition, sooner rather than later may start to become a serious option.