Depot set to make more cuts

Office Depot has said it will speed up a review of its retail operations after yesterday's disappointing quarterly results.

Office Depot has said it will speed up a review of its retail operations after yesterday’s disappointing quarterly results.

The market shaved another 5% off Office Depot’s share price yesterday (its market capitalisation is now below $470 million) after the big-box player reported a net loss of $64 million for the second quarter and easily missed analysts’ consensus estimates for adjusted earnings per share.

The headline numbers on Depot’s quarterly report card didn’t make for good reading (except for the company’s competitors, that is): total sales down by 7% to $2.51 billion (around $200 million lower in dollar terms), an adjusted net loss of $40 million and an adjusted EBIT loss of $22 million.

One of the focal points on yesterday’s conference call was the US retail division where total sales were down by 8% year on year to $994 million, with comparable store sales decreasing by 4%. Depot said the negative comps were due to the technology category and announced double-digit growth in copy and print services, growth in furniture (buoyed by own-brand seating products) and slight growth in the ink and toner category.

Nevertheless, despite a gross margin improvement, the impact of lower sales meant the retail division scraped to an adjusted operating profit for the quarter of $2 million versus $15 million in the same quarter last year and Depot announced that it was accelerating its retail estate strategy in the US.

"Aggressive" retail review

The strategy itself is not new. Depot has already committed around $30 million in CapEx this year to its retail downsizing effort which is seeing 30-35 stores downsized or remodelled and a further 25-30 outlets relocated as leases expire. This programme is now set to be accelerated as North American President Kevin Peters announced a "more aggressive" store-by-store review with around 500 store leases – about 45% of the total – expiring in the next three years.

Depot is keeping its options open as to what will happen to these stores, citing four possible courses of action: retaining the current format and location; downsizing to a smaller format; relocating the store within the same market; closing the store down altogether. A final plan will be announced later this year, but major restructuring does seem likely and Depot has warned that capital commitment per year could be double this year’s figure and that "significant" impairment charges could result. CFO Mike Newman said that the subsequent higher CapEx allocation and lower free cash flow could be handled from a liquidity perspective.

Remodels and relocations undertaken so far this year have resulted in an average square footage reduction of 40% at the affected stores, while Depot says that 90% of sales have been retained, and new staff training has resulted in positive comps of 3% versus control stores.

CEO Neil Austrian said that costs were also being cut in non-customer facing roles in both the Boca Raton head office and in Europe. This resulted in $9 million in restructuring and ‘business process improvement’ charges in the second quarter, $6 million from the US and $3 million from Europe.

European concerns

Europe was again a drag in the second quarter, mainly from the Viking direct sales business. International division sales were down by 6% in constant currency (4.4% after the impact of fewer working days in the quarter compared to 2011), but it was revealed that Viking’s sales were down in the high single digits as it struggles with the transition from a predominantly catalogue and mail order business to an online reseller. International President Steve Schmidt said the increasing presence of online "category killers" and companies such as Amazon were a factor and that Viking needed to improve its customer experience. He announced the setting up of a review of the direct business with the appointment of "channel experts". Schmidt also pointed to the existence of multiple IT platforms in Europe and said that funds had already been earmarked to move to a centralised platform.

Contract sales in Europe decreased in the low single digits while retail sales fell in the mid-single digits due to declines in Sweden and Hungary. Retail sales in France were flat, helped by the presence of Apple products which lifted the technology category as a whole.

Schmidt referred to the European cost structure and it would not be a surprise to see the scaling back of some operations, for example the Hungarian retail business. No mention was made, however, of a potential successor to Dirk Collin as head of the EMEA region. Anecdotal evidence suggests a positive reaction locally to Schmidt, with a greater level of ‘hands-on’ involvement, so Depot may be biding its time over the Managing Director EMEA role.

Asia reported growth in both the contract and retail channels, and the joint venture with Gigante in Mexico continues to develop despite last quarter’s unfavourable exchange rate comparison. Local currency sales were up by 11% and Depot said that there was still potential to grow in other Latin American markets.

The least negative of the reporting divisions was North American Business Solutions (BSD) where Q2 sales were down 1% year on year to $796 million and operating profit of $45 million was $5 million lower than a year earlier. Positives included a high single-digit increase in the cleaning and breakroom category, growth in the healthcare vertical, and improved sales from existing large customers.

Given the recent investments in the in-house small business unit in Texas, it’s debatable whether the "slight" increase in sales to SMB customers could be viewed as a positive result; certainly, the unit was not singled out on the call as it had been in previous quarters.

Summing up, CEO Austrian said that Depot had "many levers to pull" as it sought to "proactively" respond to continuing economic and industry headwinds. In reality, that looks like meaning another US retail shake-up, further headcount reductions in Boca Raton and Venlo and tricky IT integration in Europe – all of which will burn cash in the near-term with the hope of a longer-term payback. For Office Depot’s sake, let’s hope its shareholders are in a patient frame of mind.