Investment in distribution begins to bear fruit - Power Retailer: Office Max

DSN Retailing Today, Nov 11, 2002 by Mike Troy

It is premature to say that OfficeMax is on a roll, but after two years of losses and weak sales growth, the company has reversed those trends and its prospects have improved.

The company is enjoying industry-leading same store sales growth and is on track to end the year with a profit and virtually no debt. An efficient new distribution center network and merchandise planning and allocation systems. have dramatically reduced inventories, improved the efficiency of store operations and enabled the company to pursue a smaller footprint prototype. In addition, OfficeMax competes in a growing market, where scaled back expansion plans of the three leading players are focused, for the time being anyway, on existing markets.

The bottom line on all of these developments is OfficeMax should report a full-year profit of approximately $6 million on sales of nearly $5 billion and is positioned for an even more profitable year in 2003. It is a turnaround that has been a long-time coming and one some skeptics thought might never get here. However, OfficeMax has always known the source of its problems was an inefficient, essentially nonexistent distribution system that hindered its efforts to compete with larger rivals, including Staples and Office Depot, rather than a base of stores that oftentimes looked as good, if not better, than its rivals and offered virtually the same products and services at competitive prices.

Where OfficeMax finds itself today is on the cusp of achieving significant improvement. It spent the past four years building a network of three PowerMax distribution centers and is now beginning to reap the benefit of that investment with about 95% of the merchandise in the company's approximately 950 stores flowing through those facilities. Since OfficeMax is no longer as dependent on suppliers to ship merchandise directly to stores as it was in the past, it can operate stores with leaner inventories and is more likely to have product in stock.

In turn, OfficeMax is able to improve the appearance of stores by eliminating tall metal fixtures that used to be necessary when large amounts of overstock had to be kept on hand because the company lacked the ability to replenish stores rapidly. The reduction of inventory levels in just two years has been significant. At the end of the most recent fiscal year, inventory was valued at $884 million compared with $1.27 billion just two years earlier.

In addition to an improved inventory situation, OfficeMax's credit situation also has improved. Borrowings under its credit line peaked at $220 million during the fiscal year ended Jan. 27, 2001. However, at the end of the most recent fiscal year, borrowings were reduced to $20 million.

Even though expectations are high that OfficeMax will achieve full-year profitability, the key issue surrounding the company is whether recent improvements are an indication of better things to come or simply a function of easy comparisons against past results.

"The real question is the outlook for 2003 and beyond," Lehman Brothers analyst Jeff Black said when he initiated coverage of the company on Sept. 10. "OfficeMax's [operating margin] is 200 to 250 basis points less than those of its rivals, and with no contract stationer business, margin expansion will have to come from store productivity."

Black believes it will be possible for OfficeMax to improve its margins primarily as a result of distribution and merchandising improvements.

"The stores are looking better, and with virtually no debt we believe OfficeMax can be a long-term player in the office products sector," Black said.

Not everyone is convinced, however, especially when OfficeMax's accomplishments are viewed with a more cynical eye. For example, OfficeMax's same store sales went from flat during the first quarter to a 3.4% increase in the second quarter to a projected 7.5% during the third quarter. That's a nice progression, but those gains follow negative comps in the two previous years; comps that lagged behind its competitors, as well.

The company highlighted its performance during the seasonally weak second quarter as one of progress, in part because the loss it reported was less than analysts had forecast.

"As has been the case for almost a year now, the company gradually coaxed estimates down over the course of the quarter to report an upside surprise," J.P. Morgan analyst Danielle Fox noted at the time.

Banc of America Securities analyst Aram Rubinson added, "It is hard for us to get too excited about a money-losing quarter, particularly one in which the tax rate plays a significant role in determining pro forma earnings."

Shortly after announcing second quarter results, OfficeMax trumpeted its performance during the first six weeks of the third quarter, noting that same store sales were tracking in the mid-single-digit range. Continued sales improvement caused OfficeMax to announce on Oct. 4 that it expected a 7.5% same store sales increase for the quarter ended Oct. 26.

With continued sales improvement, the retailer is on track for a profitable year, but that profit has come at great expense, with OfficeMax having earned a reputation for taking frequent accounting charges in relation to efforts to reposition itself. OfficeMax took a $76.8 million charge last year related to the closing of 29 stores and it took a $109.6 million charge in 2000 related to the closing of 48 stores. In 1999, there was a $77.4 million charge related to inventory markdowns and item rationalization, and in 1998, OfficeMax took an $80 million charge to write off its computer business.