Staples preparing for International cuts

Disappointing Q2 results likely to spark major changes, especially at the International division.

Over the last three or four years there have been what could probably be described as intermittent ‘glitches’ in Staples’ quarterly results, but, on the whole, it has largely outperformed its two main big-box rivals Office Depot and OfficeMax – especially in North America – and has widely been seen as enjoying a leadership position in areas such as developing adjacent categories and services, e-commerce and operational efficiency.

There were expectations – given the recent positive results from OfficeMax in US contract (+2.6%) and retail comps that were virtually flat – that Staples would once again show that it was leading the way in the sector. That all came crashing down yesterday as all three of its operating divisions recorded declines in sales and operating profit. Total company sales for its second quarter fell by over $321 million to $5.5 billion (although around $143 million of the drop was due to unfavourable currency translation), gross profit margin declined, and net profit fell by almost 32% to $120 million. Both the top and bottom lines fell some way short of analysts’ consensus forecasts and this – along with a weaker outlook for the rest of the year – caused Staples’ share price to shed 15% yesterday to end at its lowest level for around nine years.

There was certainly a lot of interest from the analyst community on yesterday’s conference call. 17 of them took part in a Q&A session that went on for over an hour as they tried to dig deeper into the reasons for the lower-than-expected results.

Ron Sargent is usually the first to say when he feels the company is underperforming, and yesterday was no exception. He said he was "not satisfied" with the Q2 performance and called the result from the International division "particular disappointing".

The International division has been experiencing a challenging environment for some time, but a Q2 local-currency sales decrease of 10% was even worse than the company had expected. Staples has exited markets such as the Czech Republic and Hungary over the last three years, but has so far resisted making more aggressive withdrawals. That could now change with the company promising to reveal a set of turnaround initiatives in the coming few weeks.

International President Mike Miles said that "everything was on the table" and that "tough decisions" would have to be made, suggesting that the company would now be prepared to make more fundamental – and costly – changes. At an investor day almost two years ago, Staples outlined its international strategy and identified its key growth markets. Australia, China and Brazil were on that list, so unless there has been a strategic shift since then, they are unlikely to figure in any major restructuring in the coming months. In any case, Australia – where there was a double-digit drop in sales in the last quarter – has already seen its headcount reduced by 15% in the last 12 months and Staples is anticipating an improving performance in the back half of the year. Latin America and China are also narrowing their losses, although with Mike Miles stating that the company’s patience was "reaching its limit" with certain loss-making businesses, nothing can be discounted at this stage.

India dispute

It is unclear what might happen with Staples’ Indian operations. In the company’s quarterly 10-Q filing with the SEC, it was revealed that Staples is looking for an amicable solution to a dispute with joint-venture partner Future Group and other shareholders over the valuation of the Indian business.

Staples owns just under 40% of the joint venture but said that the other shareholders had "purported to exercise put option rights" last month that would require Staples to purchase the rest of the business "at a fair market value". The sticking point is the fair value estimate of the Staples Future Group. Staples disagrees with the $89 million figure that two valuation firms arrived at which would mean Staples forking out $54 million for the remaining shares. Staples pointed to "methodological flaws" in the valuation process which is leading it to state that the options were "improperly exercised" by the shareholders. Staples is currently looking to resolve the dispute amicably, but said that it would "vigorously" challenge the exercise of the options if it could not reach an agreement. It also warned of a possible "material" loss that could be recognised if it was forced to acquire the shares at the current valuation.

It would appear that most cuts will have to come in Europe. UK retail is likely to get another reprieve as it is already in turnaround mode with a number of store closures, relocations and revamps recently. It was also on that strategic list from two years ago, as were Germany and the Nordics region. Therefore southern Europe is bound to come under close scrutiny with its economies not forecast to rebound any time soon. The 35-strong retail store network in Portugal would seem the obvious place to start. Other possible reductions could come in contract operations in France and Italy (both countries have relatively strong direct businesses) and in the Dutch retail channel.

Changes will not be restricted to the International division with Ron Sargent saying that there would be reductions across all areas of the company. One key area is US retail where, like Depot and ‘Max, Staples is reducing the size of its stores, and the CEO said that square footage reductions were a top priority. 600,000 sq ft (60,000 sq m) is being taken out of the network this year and, with around 400 leases up for renewal in the next two years, that figure is likely to increase.

The big driver of retail sales declines in the second quarter was the technology category with double-digit decreases in the computer and software categories. Staples is reallocating space in its tech offering in around 1,200 of its stores, reducing shelf space of products such as digital cameras and software.

One area that Staples is not cutting back on is its e-commerce platform. In fact, investments there were a major reason for margin declines in the second quarter due to pricing and customer loyalty initiatives. Sales, though, were up in the low single digits, representing a sequential decline in growth from the first quarter.

Clearly, the focus over the next few weeks will be on Staples’ International operations. It would not be a surprise to see some markets exited altogether with the macro-economic situation in many European countries not expected to improve in the near term.