ODP Corp

NASDAQ:ODP

Earnings Call Transcript 2018-Q3

[Operator]

Good morning, and welcome to Office Depot's Third Quarter 2018 Earnings Conference Call. All lines will be on a listen-only mode for today's call after which instructions will be given in order to ask a question. At the request of Office Depot, today's call is being recorded.

I would like to introduce Tim Perrott, Vice President, Investor Relations. Mr. Perrott, you may now begin.

[Timothy J. Perrott, Two Harbors Investment Corp.]

Good morning, and thank you for joining us for Office Depot's Third Quarter 2018 Earnings Conference Call. This is Tim Perrott. I am here with Gerry Smith, our CEO; and Joe Lower, our Executive Vice President and CFO. On today's call, Gerry will provide an update on the business, including highlights of some of the noteworthy achievements during the quarter and our progress towards our transformation. Joe will then review the company's quarterly financial results, including our divisional performance, as well as provide an update on our guidance for 2018 and on initial guidance for 2019. Following Joe's comments, Gerry will have some closing remarks, and then we'll open up the line for your questions.

Before we begin, I'd like to inform you that certain comments made on this call include forward-looking statements, which are subject to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements reflect the company's current expectations concerning future events and are subject to a number of factors and uncertainties that could cause actual results to differ materially. A detailed discussion of these factors and uncertainties is contained in the company's filings with the SEC. During the call, we will use some non-GAAP financial measures as we describe the business performance.

The SEC filings, as well as the earnings press release, presentation slides accompanying today's comments and reconciliations of the non-GAAP financial measures to the most directly comparable GAAP financial measures are all available on our website at investor.officedepot.com. Today's call and slide presentation is being simulcast on our website and will be archived for at least one year.

I will now turn the call over to Office Depot's CEO, Gerry Smith.

[Gerry P. Smith, Office Depot, Inc.]

Thank you, Tim, and good morning to everyone joining our call today. It is great to be here with you this morning to discuss our results for the third quarter and the significant progress that we are making on our transformation efforts. Our results this quarter again provide tangible evidence that we are well on our way to achieving our goal and building a more sustainable business that will provide benefits for all of our stakeholders.

In the quarter, we strengthened our core business and drove very strong results in our BSD division, with sales growing on both an organic and total basis. We continue to grow our high-margin service businesses, driving double digit sales increases in services in both our BSD and Retail segments.

We continue to invest in the expansion of our distribution and supply chain network capabilities, the backbone of our business and one of the key assets of our company. And, importantly, we generated very significant free cash flow and further strengthened our balance sheet. Overall, we are making great progress and we are ahead in all key financial measures relative to the guidance we provided at the beginning of the year.

Beginning on slide 4, I'd like to share with you some of the specifics of our strong third quarter financial highlights beginning with sales growth. As we had mentioned in the past, strengthening our core business and gaining traction in sales growth has been our number one priority during the initial phase of our transformation plan. Our sales results, again, this quarter show that we are making great progress in this area as we generated revenue of $2.9 billion, a 10% increase versus the prior year. While the acquisition of CompuCom clearly played a major role in our overall year-over-year growth, we are very pleased to see improving trends in our core business.

In our BSD division, which is our B2B distribution and eCommerce businesses, we grew revenues 6% over last year, and most importantly, sales were up on an organic basis approximately 1% as compared to down 5% organically in the third quarter of 2017. Our growing B2B business continues to be the largest part of our enterprise, representing approximately 60% of our total revenue.

In our Retail Division, although sales declined 6% in the quarter versus prior year, we have shown improving trends on a year-to-date basis. Excluding the impact of the new revenue recognition standard, retail sales trends improved 500 basis points as sales were down 5% year-to-date 2018 compared to down 10% during the same year-to-date period in the prior year.

Both of these improvements offset lower revenue at CompuCom. As I will elaborate later, CompuCom was impacted by lower sales from one of its largest enterprise customer, who is currently experiencing a significant reorganization of their business.

In addition to strengthening the core, our growth strategy is also focused on creating a powerful omni-channel business services company. I am pleased to report that services revenue continued their positive growth trends in the quarter. Total services revenue has more than doubled from what it was a year ago. While much of this increase came from the CompuCom acquisition, I want to highlight that we accelerated services revenue growth outside of CompuCom.

Services revenue across our BSD and Retail Divisions combined grew 17% in the quarter. This strong performance is a result of the traction in the enhanced services and subscription-based offerings that we began rolling out earlier this year.

Our profitability remains solid in the quarter despite the investments we are making to position us for future growth and the disappointing results of CompuCom. We are continuing to invest in building our service capabilities and investing to improve customer experience. We are deploying new technology in our stores, distribution centers and websites, and we are investing in stimulating demand generation for our new services. With this in mind, we generated operating income of $105 million, flat with last year, and adjusted operating income of $120 million. Adjusted EBITDA for the quarter was up 3% to $172 million.

This leads us to free cash flow generation. Through our continued operational discipline and focus on working capital, we drove extremely high levels of free cash flow in the period. We generated $257 million in free cash flow in the quarter, resulting in $434 million year-to-date, already surpassing our guidance for all of 2018.

This is a significant accomplishment, particularly when considering the continued investments we are making in our business this year. And very importantly, our cash position grew to $925 million at the end of the third quarter. Joe will highlight our balanced approach to capital deployment later in his remarks.

And finally, as a result of the progress we've made in driving our business priorities, we are raising our guidance for 2018. We're also issuing guidance for 2019, which highlights both sales growth and our efforts to drive higher margins throughout our business. Joe will cover this in his prepared comments.

I will now elaborate on a few additional highlights in the quarter that support key elements of our strategy and the pivot we are making as a company. Throughout the year, we have strengthened our core, and the best evidence of this can be found in the strong performance in our BSD division as shown on slide 5. As you know, BSD is our B2B distribution and eCommerce business. The strong growth trends that started a year ago have continued as our BSD division has delivered its third quarter in a row of positive sales growth.

Most importantly, BSD grew organically in the quarter, representing its best performance in over a decade, and we believe there is more to come. I'm very proud of the team and their success in dramatically changing the trajectory of this critical piece of our business.

There are several factors underpinning the success as shown on slide 6. First, we carried our customer-focused mentality into a reorganization of our selling resources last year that is leading to improved customer acquisition and retention trends. These efforts have increased our customer satisfaction scores across all channels and help us build a strong pipeline of new business.

Second, our focus on demand generation and the shift we made last year towards digital marketing is enabling us to more efficiently and effectively engage with customers. For the third quarter in a row, we've seen positive sales, traffic and conversion rates in our eCommerce business. Third, we are capturing additional growth through many cross-selling opportunities with CompuCom. More sales leads are being generated as a result of our combination, and we are capitalizing on these opportunities.

One of the key growth drivers is our adjacency strategy within BSD. This includes categories such as cleaning and breakroom, copy and print, furniture and technology products. All adjacency categories grew in the quarter, and they now account for approximately 37% of total BSD sales.

We began aggressively pursuing this strategy late last year, and have built capabilities across the organization to support this growth opportunity. This included adding dedicated selling and operational resources with deep industry experience as well as partnering with key vendors to add new SKUs to our assortment in order to capture a larger share of wallet within our current customer base.

We believe the cleaning and breakroom category in particular, which includes Jan-San offers significant growth opportunities as the industry is highly fragmented, and we generally have a low level of penetration in our existing customer base. Overall, our adjacency business has grown 13% year-over-year and I believe we are still in the early stages of capitalizing on this growth opportunity.

I would like to spend a few moments on our progress in growing our services offering as shown on slide 7. As the primary component of our transformation strategy, we are continuing to gain traction in our services businesses and are encouraged by the trends we are seeing and the opportunities before us.

Services in both BSD and Retail continue to grow over last year as our efforts to drive demand and improvements in our service capabilities continue to gain traction. We also drove growth in all of our major service categories. Copy and print services, which includes services such as print marketing services, documents and finishing and pack and ship, grew in the third quarter.

We also won key new business contracts for print services in our BSD division. Copy and print is a very large market for us, and we are continuing to launch new initiatives designed to drive additional growth. Among these are our new online photo configurator, social media upload capability and deployment of Auto Pay functionality on the device.

In our tech services category, which includes services such as device managed services, 24/7 tech support and device protection among others also exhibited growth in the quarter. We are also launching new services and capabilities, including IT-as-a-Service and Software-as-a-Service as well as storage and shredding service, which is already showing strong signs of demand. We are also working to build reoccurring relationships with our customers by offering the convenience of subscription-based services. We offer subscriptions for a wide array of products, including office supplies, breakroom supplies and software licenses among many others.

We have continued to gain significant traction for these subscription-based services and we have improved our point-of-sale systems to our customers to sign up quickly while in our stores or online. Our subscription business is growing rapidly, and it's climbed to approximately 700,000 subscriptions at the end of the third quarter, up more than double from the end of the second quarter in 2018.

As we introduced during our Investor Meeting in May of this year, Workonomy is the umbrella experience and brand for our expanded SMB service offerings. Workonomy will drive sustainable, profitable revenue growth by propelling Office Depot's share of business services and by driving reoccurring revenue streams.

We achieved this by being the most accessible and most comprehensive business services solutions for SMBs through our retail stores, online and by appointment in our customer's location. Our highly certified technicians in the field from CompuCom and in our stores will serve our SMB customers when and where they need service.

The services range from diagnostics, installs and repairs, to a complete managed IT-as-a-services solution as well as marketing and administrative services and our proven industry-leading copy and print solutions. Our role on their team is to provide the necessary support services so they can focus on what matters most to them: growing their business.

We are rolling out Workonomy in a more visible manner in the fourth quarter of this year. As a result of our efforts, I am pleased that we are were to grow services revenue 28% in our BSD division and 11% in our Retail Division, excluding the impact of the new revenue recognition standard. Importantly, you will note that the average gross margins in our services are approximately 1,000 basis points higher than that of our products margins.

We are very encouraged by these trends and are excited by the very large market opportunity in front of us. Our improving capabilities put us in an excellent position to exploit this opportunity and drive significant growth in services in the future.

Turning to slide 8, I'd like to now spend a few minutes discussing our Retail business and the approach we're taking to enhance customer experience and drive demand. We continue to invest in the capabilities of our associates, enhancing in our services platform and improving the in-store experience. Having highly motivated and qualified retail associates is a competitive advantage and paramount to improving the in-store experience for our customers. To this end, we have realigned our field organization to better serve customer needs and drive services.

We are also investing in the capabilities of our field associates by providing training to help them develop stronger customer relationships and effective selling skills. For example, we recently completed our second Depot Days of Training event for over 20,000 of our associates to develop stronger selling skills and expertise around our new services and subscriptions offerings.

We are investing to develop more productive sales associates instead of order takers and stockers. We are already seeing the benefits of this as customer satisfaction scores have been on the rise and service attach rates are increasing. Additionally, we have more customers joining our loyalty program, which is particularly encouraging as loyalty customers spend twice as much on average than our non-loyalty customers.

We are continuing to invest in our services platform and capabilities, rolling out new services and enabling technology to officially bring them to market. We're also investing to improve our in-store experience and modifying our store layout, highlighting our services capabilities up front with a focus on customer care. We are also investing in cost-efficient LED lighting upgrades, benefiting appearance (00:18:44) and energy costs and in the in-store broadband experience with technicians available to serve our customers' specific needs.

We're also thinking about our Retail space differently and are evaluating additional ways to drive value from our footprint. For example, we're continuing to evaluate store within a store opportunities to drive increased traffic and bring expanded offerings to our customers.

We are designing our stores to be more service-oriented, making it easier for SMB customers to access our technical expertise and buy our services. We're also taking a more localized approach in our communities both in terms of reaching out to customers and in terms of services offered leading to an increase in demand. One of the areas that we remain very excited about is the co-working opportunity and the early positive feedback we are receiving.

At our store in Los Gatos, California, we have launched an attractive co-working offering, and while we are still early in the test and learn phase, I'm pleased to report that demand for this service has been very strong and customer feedback has been terrific.

Early results are also showing better in-store demand at this location, driving higher sales for both services and products than in our average store. We are excited about this opportunity and are planning additional test and learn opportunities in the co-working space in the coming year.

As I stated in the past, I view our Retail footprint as a key component of our omni-channel strategy and one of our primary differentiators versus online or distribution-only competitors. It allows us to deliver an increasing spectrum of services and solutions as our customers prefer human interaction when making a purchase.

Of our approximately 10 million SMB customers, nearly 6 million of those are within a 3-mile radius of our stores. The importance of this Retail presence can also be seen in the continued increase in sales of our Buy Online and Pickup in Store offering, which is up over 25% year-to-date compared to last year.

We also continued to drive value through our back-to-school season. In a heavily consumer-dominated selling season, our early preparation and enterprise-wide efforts drove solid back-to-school results, meeting our plans in the quarter. On a relative basis, our back-to-school performance was particularly strong in the education area of our B2B business. We realized many operational improvements from the prior year, and are already incorporating those best practices into our 2019 planning. Back-to-school will continue to be an important opportunity as we continue to expand in education-related offerings. I am very proud of our team and with all these accomplishments that have contributed to our improving sales trends relative to where we were a year ago.

I'd now like to take some time to discuss our progress with CompuCom. As shown on slide 9, the CompuCom acquisition brought unique capabilities that are a competitive differentiator allowing us to grow our services business and to attract new business-oriented customers and valuable distribution partners. We are already seeing successes in cross-selling opportunities across the business, and we are scaling CompuCom capabilities to address the large SMB opportunity.

Although we are pleased with this progress, CompuCom's operating results for the quarter were clearly disappointing. Their results were impacted by lower sales from one of its largest customers, which is currently experiencing a significant reorganization of its business. Unfortunately, this had a negative impact on both sales and operating income. Excluding this impact, sales would have been essentially flat year-over-year. That being said, we have taken several actions to improve future operating performance.

First, we have recently reorganized their entire customer-facing organization and have introduced a dedicated customer success leader to ensure better alignment of our clients' needs. Second, we are streamlining the structure within our operations groups, removing layers and flattening the organization to significantly improve services velocity and accountability. This creates a more agile organization and improves the speed and efficiency in which decisions are being made. We are pursuing opportunities to automate many of the routine tasks within the organization to improve efficiency and reduce costs. We expect that these operational initiatives will improve customer satisfaction, improve order fulfillment and service delivery and reduce cost in the organization.

And, third, we have realigned our sales teams to more effectively pursue new customers and identify opportunities for growth within our existing customer base. Heading this team, we have brought in a new sales leader with significant industry experience to help us pursue the numerous opportunities for growth. I'm very encouraged about all of these initiatives and expect that these and other actions will have a positive impact on CompuCom's performance over the next several quarters.

That said, we also remain very encouraged by our new customer growth as CompuCom drove nearly a 60% increase in service order wins over last year, marking their fifth consecutive quarter of year-over-year growth in service orders. Year-to-date, they have already far surpassed the number of new logo wins as compared to all of 2017. This strong traction bodes well for the future as their customers, on average, remain with CompuCom for over a decade.

CompuCom was a key first step in our transformation strategy and an important strategic asset for us in developing our services business. Their world-class service offerings differentiate us from the competition and positions us for opportunities and partnerships that we could not pursue without them.

As you heard me say in the past, the true power of this acquisition comes from combining this services-rich business with our customer-rich business to unlock a powerful growth opportunity. We are leveraging these capabilities across our entire omni-channel platform that has access to millions of customers.

We've already captured several cross-selling opportunities, including a major energy business that was introduced to CompuCom's award-winning IT services. Year-to-date, we have captured several major contract wins via our combined relationship, totaling over $70 million in total contract value. These opportunities are only made possible by our combination with CompuCom.

Turning to slide 10, I'd now like to talk about how we are expanding our distribution and supply chain network and capabilities. As the backbone of our business, our supply chain network continues to expand and provides a significant competitive advantage to our business. Our supply chain network is approximately the 20th largest in North America with ability to provide next-day delivery services to over 98.5% of the U.S. population as well as a unique capability to deliver directly to the desktop. Very few in the industry have this capability on a national scale.

We have over 50 strategically located distribution centers, cross docks and combination facilities representing over 9 million square feet of space. This is supported by a dedicated fleet of over 1,000 transportation vehicles serving Office Depot and affiliates and last-mile infrastructure to ensure seamless service for our customers. This network is a critical differentiator for us both in terms of supporting our business operations as well as in positioning us to pursue other commercial opportunities.

We are investing in several areas of our network to further enhance our capabilities and increase efficiency and lower costs. We are growing our private fleet and making upgrades to our facilities with new automated technology and robotics. We are implementing new supply chain orchestration software to gain better visibility into our system and to improve performance. We are also installing new software that optimizes our network and allows greater insight to supply chain costs down to the SKU level, providing the ability to make more informed decisions and improve profitability.

Additionally, we are expanding the reach of our distribution network by identifying and acquiring profitable regional distribution companies in geographic areas that were previously underserved by our network. This has allowed for an effective and accretive means to expand our distribution reach and target new business customers.

We are excited by all these investments and the operational benefits provided. This also positions us to pursue opportunities beyond our traditional business such as utilizing our supply chain as a service for third parties. We recently signed a number of third-party customers, including three notable companies in which we will provide backhaul services utilizing our trucks that are otherwise returning from deliveries empty. I am excited by these wins and the opportunities to grow supply chain services in the future.

Hopefully I've conveyed the traction we are gaining across our businesses and the growing confidence I have in realizing our potential as a unique omni-channel business services provider.

With that, I will turn the call over to our CFO, Joe Lower, for more detail on our financial results.

[Joseph T. Lower, Office Depot, Inc.]

Thank you, Gerry, and good morning, everyone. I'm happy to be here today to discuss with you our third quarter results. As we have in the past, we have provided our results on both a GAAP basis and adjusted basis from continuing operations. My comments will primarily address the performance from our continuing operations on an adjusted basis.

Also, keep in mind that the total company financials include the results for the CompuCom Division for the third quarter of 2018 only, as this business was not part of Office Depot in the prior-year period.

Turning to slide 11, we have highlighted some key performance measures for the third quarter of 2018. Total company sales for the third quarter totaled $2.89 billion compared to $2.62 billion in the same period last year. The increase of 10% was driven by the addition of our CompuCom results for the third quarter in 2018 as well as continued sales growth in our Business Solutions Division, which more than offset a decline in sales within our Retail segment.

Underlying the improving sales trends, service-based revenue grew across our business with BSD and Retail generating a combined 17% growth in the third quarter, excluding the impact of the CompuCom acquisition and the adoption of the new revenue recognition standard.

On a reported basis, service revenues grew 124%, driven primarily by the CompuCom acquisition, representing 15% of total sales or more than double the 7% of total sales that services represented in the prior year.

Third quarter GAAP operating income increased to $105 million, flat with prior year. During the quarter, the company incurred approximately $14 million of operating expenses related to the merger integration, acquisition-related costs and other restructuring activities. Excluding these items, our adjusted operating income in the third quarter of 2018 was $120 million, down from $128 million in the prior year.

Both periods include a negative impact due to the change in accounting standards associated with the presentation of expense related to defined benefit pension plans. The impact was $3 million in the third quarter of 2018 and $3 million in the third quarter of 2017.

Adjusted EBITDA was $172 million in the third quarter compared to $167 million in the prior year, representing a 3% increase year-over-year. The increase was primarily associated with higher depreciation and amortization expense associated with the CompuCom acquisition that did not exist in the prior-year period.

Excluding the after-tax impact from the items mentioned earlier, third quarter adjusted net income from continuing operations was $71 million or $0.13 a share compared to $74 million or $0.14 per share in the prior year.

Finally, for the third quarter of 2018, cash provided by operating activities of continuing operations was $304 million with free cash flow of $257 million. On a year-to-date basis, our company-wide focus on working capital has allowed us to generate $555 million in operating cash flow with $434 million of free cash flow.

Overall, in the context of this being an investment year, we've generated solid results in the quarter. Free cash flow performance has been particularly strong and has already exceeded our guidance for the entire year.

Let's now turn to slide 12, which highlights the performance of our Business Solutions Division, or BSD, our B2B distribution business. Reported sales in the third quarter for BSD were $1.36 billion, an increase of 6% compared to the prior year. The year-over-year increase reflects organic business growth of 1% with a balance of the growth related to our stated strategy of selectively acquiring niche players in localized markets to expand our distribution reach and increase our customer base.

Of important note, the third quarter results for BSD reflect a quarterly sequential improvement of approximately 200 basis points and continues the trend in positive sales growth that started in the first quarter of this year. Services revenue increased 28% reflecting the heightened selling focus for the strategic priority, and product sales increased 5% versus the prior year. We continued to see strength in our adjacency categories, which were up 13% over the prior year's period, reflecting improvement in both our contract and eCommerce channels.

The BSD division reported operating income of $67 million in the third quarter, compared to $71 million in the prior year period. The decrease in operating income versus the prior year was primarily driven by increased investments in demand generation and in our services platform, partially offset by higher gross margins and other cost reduction initiatives that have been implemented over the past year. I am very pleased with our performance in driving organic and total growth in our BSD division. This is a great testament to the progress we are making in strengthening our core.

Turning to slide 13, reported sales in the third quarter for our Retail Division declined 6% to $1.25 billion compared to $1.33 billion in the prior year period. On a comparable basis, after adjusting for the impact of the new revenue recognition standard, total sales were down 5%. The decline in reported sales was partly due to the impact of store closures over the past 12 months as well as the negative impact to revenue of approximately $8 million resulting from the adoption of the new revenue recognition standard. These impacts were partially offset by increases in average order volumes.

Comparable store sales decreased 5% versus the prior year, primarily driven by fewer transactions. Importantly, on a year-to-date basis, our Retail revenue trends improved 500 basis points compared to last year. This dramatic improvement is a result of fewer store closings, improved conversion and an accelerated growth of our Buy Online Pickup in Store offerings. The back-to-school season was a big contributor to our Retail results in the quarter. As Gerry addressed earlier, the results met our plans and reflected an improved enterprise-wide coordinated sales and operations effort.

Our Retail presence is an important component of our omni-channel strategy as evidenced by positive trends in our Buy Online Pickup in Store offering, which has grown 25% year-to-date versus prior year. This success reflects our concerted effort to generate incremental demand through our digital marketing capabilities and leverage the benefits of our unique omni-channel platform.

Product sales in the third quarter decreased 7% while services revenue increased 11% compared to the prior-year period, excluding the impact of revenue recognition. Copy and print, technology services and subscriptions, all increased year-over-year. We are encouraged by the growth in services both in terms of enabling a stronger, more sustainable connection with customers and in generating higher margins on average.

The Retail Division reported operating income of $70 million in the third quarter of 2018 versus $82 million in the prior-year period. This year-over-year decrease was largely due to deleveraging related to store closures, and lower volume coupled with investments in our services platform and in-store experience, which is only partially offset by cost efficiencies. During the quarter, we closed two stores, bringing our total store count to 1,372 in our Retail Division.

Looking at slide 14, we highlight the performance of the CompuCom Division. As I mentioned earlier, reported financials include results for CompuCom in the third quarter of 2018 only as the business was not part of Office Depot in the prior-year period. However, to provide greater perspective into the year-over-year performance of this business, we have presented unaudited adjusted historical results for the third quarter of 2017 for reference purposes only.

The adjustments made to the 2017 results take into account the treatment of historical restructuring and acquisition costs to more closely align with Office Depot's reporting format. Reported sales in the third quarter for the CompuCom Division were $268 million, down 4% versus historical sales of $280 million in the prior-year period.

As Gerry addressed earlier, sales were down primarily related to a decline in sales from one of the CompuCom's largest enterprise customers as that client is going through a significant restructuring with an associate reduction in demand for CompuCom Services. After normalizing for this impact, CompuCom's revenues would have been approximately flat year-over-year.

CompuCom is gaining significant momentum in new service orders with wins up 57% in the quarter compared to last year, which represents the fifth consecutive quarter of year-over-year growth in service orders. This bodes well for future revenue as these contracts get operationalized over the next 6 to 12 months.

The CompuCom Division reported operating income of $1 million in the third quarter of 2018 compared to $13 million in the adjusted historical results. The decline in the quarter was partially due to the operational impact from previously mentioned reorganization occurring at one of its largest customers coupled with unfavorable product mix, investments to support growth initiatives and one-time accounting adjustments in the prior-year period.

Additionally, the cost of acquiring and implementing new business tends to be more front-end loaded, which also impacted profitability in the quarter. These impacts (00:40:24) lower selling, general and administrative expenses as a result of targeted cost reduction initiatives and administrative efficiencies. These results are very disappointing. And as Gerry earlier addressed, we have recently made several structural changes to improve our alignment with customer needs and brought in a new sales leader for the company. With these and other changes we are making in the business, we are confident that we will improve profitability and margins in the coming quarters.

Turning to the balance sheet and cash flow highlights on slide 15, we ended the third quarter of 2018 with total liquidity of $1.9 billion, consisting of $925 million in cash and cash equivalents and $990 million of availability under our asset-based lending facility. Total debt at the end of the quarter was $979 million excluding $759 million in non-recourse debt related to the timber notes.

For the third quarter of 2018, cash provided by operating activities of continuing operations was $304 million. This strong performance reflected continued working capital improvements particularly related to inventory and payables and included outflows of approximately $2 million in OfficeMax merger costs, $11 million in acquisition and integration-related costs and $5 million in restructuring costs.

Capital expenditures were $47 million in the third quarter of 2018. The investments reflected our commitment to continue to strengthen our core as well as to invest in our service business and future growth. Incorporating capital expenditures, we generated robust free cash flow from continuing operations of $257 million during the third quarter of 2018. Year-to-date, we generated significant free cash flow totaling $434 million, well in excess of our earlier guidance for the total year. Contributing to the significant free cash flow generation was an excess of $185 million in year-over-year improvements to working capital.

On slide 16, we highlight our balanced approach to capital allocation. Our priorities remain focused on servicing dividends, paying down debt, expanding our distribution network and share buybacks.

Year-to-date, we have generated $555 million in operating cash flow. Additionally, as we previously announced, we completed the sale of our businesses in Australia and New Zealand, generating a total of $113 million in cash.

After considering the $121 million in capital investments relating to strengthening our core and building our platform for future growth, we have had $547 million in cash year-to-date available to deploy against our priorities.

Looking now at our capital allocation year-to-date, we have paid $0.025 per share per quarter to shareholders totaling $42 million, and we have repaid $74 million of outstanding term loan consistent with our repayment schedule. We have invested $64 million in acquisitions to expand our distribution network, and we have bought back $22 million of our shares since reinitiating our share buyback program earlier this year.

After investing in our business and meeting these capital priorities, we grew our ending cash balance to $925 million by the end of the third quarter, an increase to our cash balance of over $300 million since the beginning of the year.

Going forward, we plan to continue a balanced approach addressing our business, shareholders and lenders. In particular, we are focused on reducing the burden of our existing term loan as well as continuing to repurchase shares given what we believe is a tremendously undervalued equity and one that does not reflect the cash we are generating, the strength of our balance sheet, nor the progress we have achieved in developing a more sustainable business. To this end, we have continued to acquire shares, purchasing over $9 million of Office Depot stock in October, bringing our total repurchase amount to $31 million year-to-date in 2018.

I would now like to discuss our guidance as shown on slide 17 (sic) [slide 18]. We've made excellent progress throughout the year on our efforts to reverse historical trends and regain traction and sales growth. We are tracking ahead on all of our key measures versus the original guidance we set at the beginning of this year. At this time, we are raising again our 2018 guidance for both sales and free cash flow. We now expect sales to approximate $11 billion, up from $10.8 billion communicated previously.

Our operational discipline and focus on working capital initiatives have enabled us to generate $434 million in free cash flow year-to-date, already surpassing our prior guidance for the year. We now expect to generate approximately $450 million in free cash flow by year-end. Finally, we are reaffirming our guidance for adjusted operating income of approximately $360 million and providing guidance for 2018 adjusted EBITDA, a metric we watch closely and a measure our investors frequently request. We expect adjusted EBITDA to approximate $560 million for 2018.

We are also issuing the following guidance for 2019 today. This guidance is consistent with the long-term outlook that we provided at our Investor Day Meeting in May earlier this year. We expect sales to be approximately 1% higher year-over-year to approximately $11.1 billion. Adjusted EBITDA of approximately $575 million, adjusted operating income of approximately $375 million, up approximately 4% year-over-year, and free cash flow of approximately $350 million.

This guidance reflects positive sales trends in both BSD and the Retail Divisions as well as stabilizing sales trends in our CompuCom Division. It also reflects targeted initiatives aimed at addressing supplier distribution and wage rate cost pressures and a continued focus on free cash flow generation.

Given our strong year-to-date performance and the momentum we are seeing with our key growth initiatives, we believe we are well positioned to achieve these targets. Our entire team remains focused on successfully transforming Office Depot into a powerful business services company, and believe we are on the right path to position the company for long-term sustainable growth.

With that, I'll turn the call back over to Gerry for his closing comments. Gerry?

[Gerry P. Smith, Office Depot, Inc.]

Thanks, Joe. Overall, I am pleased with our performance in the third quarter and the progress we are making in positioning our company for long-term growth. I'm excited about the traction of our core business and the initiatives we have in place to improve performance at CompuCom. We are exceeding on all key measures of the guidance we issued at the beginning of the year, and we're continuing to build momentum in the key initiatives of our plan, including recapturing top line sales growth in our core business, particularly in our BSD division, as well as improving year-to-date sales trends in our Retail Division.

Second, building momentum and driving a reoccurring and services-based business model as evidenced by the continued growth of our services and subscriptions offerings. Third, very importantly, generate strong free cash flow through disciplined operations and working capital improvements. We've exceeded our free cash flow goal for the year, and increased our cash balance to $925 million at the end of the third quarter. And lastly, enhancing our service platform and expanding our distribution network capabilities and reach. We are making solid progress and remain confident that we are on the right path.

I will now turn the call back over to the operator and we can take your questions.

[Operator]

Our first question comes from the line of Elizabeth Suzuki. Please state your company name, then proceed with your question.

[Elizabeth L. Suzuki, Bank of America Merrill Lynch]

Great. Hi. It's Liz Suzuki from Bank of America. Just a question on margins, so sales are expected to be flat to up 2% in 2019 and then you expect services revenue to continue to outgrow product and become a larger portion of the mix. I mean, given that services are higher margin, but the guidance only implies very slight operating margin improvement, are there near term investments curbing that margin outlook? Or is there some conservatism being baked in there? Or do you think that the margin on product and Retail operations are getting worse, which kind of offsets the improving mix of services?

[Gerry P. Smith, Office Depot, Inc.]

Good morning, Liz. This is Gerry. It's more of a conservative approach. As we've seen in 2018, we've overachieved all expectations for 2018. Back in May, as you remember, Investor Day, we said flat revenue-wise and a smaller proportion of that from a margin-wise. And so we're up 1% from a revenue and up a little stronger from a margin perspective.

But, yes, we, obviously, hope to overachieve, but we're being conservative. And, obviously, there are a lot of headwinds across the board and we think – whether it's labor or supply chain or other things, and we're taking that into account and we're very confident that with all the headwinds plus the services growth that we're going to achieve the plan, and I will say that, I believe, the plan is conservative. I'll let Joe comment as well.

[Joseph T. Lower, Office Depot, Inc.]

Yes. Thanks, Gerry. A couple of comments really just echoing Gerry's, first on services, you can appreciate, albeit growing quickly, it's still a relatively small percent of our business at 15% to 16% of sales.

The second thing that I just want to emphasize is we continue invest heavily to grow the business, and that will continue as we both generate demand and, frankly, continue to build the infrastructure both in distribution and our eCommerce platform. So if you will, we're trying to accomplish both, grow profitably, generate a lot of cash but continue to invest so that this transformation is sustainable.

[Elizabeth L. Suzuki, Bank of America Merrill Lynch]

Yeah, that makes sense. And then what's being baked into that 2019 operating income guidance as it relates to tariffs on imported goods from China? And how much exposure do you have to products subject to tariffs?

[Gerry P. Smith, Office Depot, Inc.]

We have baked in all headwinds into our plan, and so, obviously, we are monitoring that very closely. We have outstanding operations over in China, our global sales sourcing office and Joe and I actually spent time over there already physically, and we feel confident that we have plans in place to curtail any headwinds and still achieve our plan and make the investments. Again, we're building a business platform and we're making investments to do that. And we're confident that we'll achieve all of the above.

[Elizabeth L. Suzuki, Bank of America Merrill Lynch]

Great. Thank you.

[Gerry P. Smith, Office Depot, Inc.]

Thanks, Elizabeth.

[Operator]

Our next question comes from the line of Kate McShane. Please state your company and then proceed with your question.

[Kate McShane, Citigroup Global Markets, Inc.]

Hi. Thanks. Citi. Thanks for taking my question. I had a few questions around CompuCom, a couple shorter term questions and then one longer term question. I just wondered with regards to the large customer reorg, is there a chance that those sales come back? And then I wondered if you could walk us through the margin puts and takes for CompuCom. What would it have been ex-the change in the large customer? And if product mix was a bigger issue, how do you control that going forward?

[Gerry P. Smith, Office Depot, Inc.]

Yeah, of course, there is always opportunity to have a customer recover. I want to be really clear, though. I'm really pleased we've hired Mike Zimmer who is a very, very experienced services sales leader from Xerox. He spent many years there. He's taking over – he came onboard in mid-October. I have a lot of confidence in him plus the current team we have. And we're going to focus on driving sales growth across the business. And I think that's imperative. If we get the large customer to come back, that will be icing on top of the cake.

So from a CompuCom perspective, we definitely have – we're going to get through – we've already invested and we're investing in the sales model. I will say that there are some operational issues with the change of leadership midyear. We've dug into the business more. What I saw some of the operational issues early at Office Depot, we're seeing at CompuCom as well. We have a transformation team that is doing a great job of working with the operational leaders at CompuCom, and we think we can do even a better job at driving customer retention and drive some operational cost improvements, which will help margins as well.

And so there's an operational focus, and there's a sales focus. Those are the two key things that we're driving. And then lastly, the reorganization of being – we're putting some of our top leaders across many of our key accounts to make sure we even achieve higher customer sat and try to drive share of wallet there as well. Plus, lastly, the cross-selling is kicking up and starting to work, and we need more of that across both Office Depot and CompuCom.

Joe, why don't you add in some comments on margin.

[Joseph T. Lower, Office Depot, Inc.]

Yeah, just on the margins, I would say, one, we're not going to comment on specific customer and profitability, but if you look at the challenges in the quarter, they really fall into three buckets. You have the single customer issue; you have the issue that Gerry referenced, which is operationally just, frankly, not being as efficient and productive as can be; and then, third, you have some kind of relatively one-time items associated with just operations. I think as you look to fourth quarter, you will see improvement as a result of particularly the one-time items being less relevant. And as we continue to improve the operations, I do anticipate margins will improve 2019 over 2018.

[Kate McShane, Citigroup Global Markets, Inc.]

That's very helpful. Thank you.

[Gerry P. Smith, Office Depot, Inc.]

Thank you.

[Operator]

Our next question comes from the line of Michael Lasser. Please state your company name, then proceed with your question.

[Michael Lasser, UBS Securities LLC]

Good morning. Thanks a lot for taking my question. It's Michael Lasser from UBS. So as you look to next year and your guidance of $15 million of incremental operating income, what have you assumed about the core business? Because it seems like it's going to be a challenge to get there in light of the fact that your operating income year-to-date has declined by $75 million year-over-year.

[Gerry P. Smith, Office Depot, Inc.]

Well, Michael, I'll say it again. We've reset our expectations beginning the year. We're actually understand the decline from the previous year. A lot of that was driven through store closure and other things. We're not doing that anymore. We're driving structural improvements. I think a lot of people didn't believe us that we could grow BSD three straight quarters in a row, which we've done. We're making progress on services substantially. And I think the progress we made on free cash flow will allow us to invest to grow even more and drive more margins from the business.

I'm very pleased with the structural earnings we're getting out of our core business. We've definitely strengthened our core this year. It's sustainable earnings, which are important. And I think I'm confident that the plan we have in place is, again, in May we said flat, and now we're going up from – and I think a lot of people didn't believe that we could actually have a reset year and grow the business again. And we're committed to do that, and we're very pleased that – let's step back for strategy for a second.

I've always said we have to get the sales engine working first. That's doing that now. I've said we're going to drive the cash flow engine. We're doing that now. And we're going to put even more emphasis on – we have the first two working now, driving the profit engine as well and we'll have a number of profit initiatives across 2019 that we think will help us accelerate and make the core even stronger. I'll let Joe add a few comments and color on that as well.

[Joseph T. Lower, Office Depot, Inc.]

Yeah. The only kind of commentary I'll add in addition is if you just look at it at a high level, we have the benefit of growing services which, as we've mentioned kind of repeatedly, has a higher on average margin. We anticipate improved performance at BSD. And we expect improved performance at CompuCom, which enables us to, obviously, recognize some operating leverage between the 1% sales growth and 4% operating growth. And those are the primary drivers that get you to the year-over-year improvement.

[Michael Lasser, UBS Securities LLC]

Two more questions. One is how does the 1% organic BSD growth this quarter compare to where it was last quarter and the prior quarter?

[Joseph T. Lower, Office Depot, Inc.]

So if you go back a year, it's 500 basis points improved organically year-over-year. So, 200 basis points from last quarter, 500 basis points year-over-year.

[Michael Lasser, UBS Securities LLC]

Okay. So 200 basis points of acceleration both organically and on a reported basis from the second quarter?

[Joseph T. Lower, Office Depot, Inc.]

It is approximately correct.

[Michael Lasser, UBS Securities LLC]

Okay. And then on the free cash flow, given that you're guiding $450 million this year, $350 million next year, and you saw a big boost from the improvement in working capital, should we consider $100 million of that working capital gain that you experienced this quarter as one-time in nature?

[Joseph T. Lower, Office Depot, Inc.]

If you look, kind of by definition working capital improvements are one-time in nature, and the challenge that we have for ourselves is how do we continue to generate incremental one-time benefits. Right? Just you appreciate how working capital works and then you improve working capital by improving terms, extending payments, accelerating receivables, all of which we have done very successfully, and we will continue to do. But as we looked at year-over-year kind of baseline $350 million is significant free cash flow generation which, clearly, we will strive to improve as we continue to work all levers of the balance sheet.

[Michael Lasser, UBS Securities LLC]

Okay. Thanks very much.

[Gerry P. Smith, Office Depot, Inc.]

I'll add something to that.

[Michael Lasser, UBS Securities LLC]

Yeah. Go ahead.

[Gerry P. Smith, Office Depot, Inc.]

The structural improvements we made, though, on payment terms, working with our partners, on improvements in DSO, some robotics and automation we put in place as well, the good news is the engine is built now. And so I want to highlight from 18 months ago to today, there is substantial improvements of the engine of generating cash which will allow us to continue to reduce the burden of the debt, pay dividends, buy back stock, invest in the company, invest in supply chain, all the things we need to do to run the business. And so our return on invested capital has improved dramatically. Thank you for the question, Michael. Appreciate it greatly.

[Michael Lasser, UBS Securities LLC]

Thank you, Gerry.

[Operator]

Our next question comes from the line of Christopher Horvers. Please state your company name, then proceed with your question.

[Christopher Horvers, JPMorgan Securities LLC]

Thanks. Christopher Horvers, JPMorgan. So given the brighter free cash flow outlook, I know you're focused on paying down debt and buying back the stock. But is there an opportunity to restructure your term loan? It looks like it's LIBOR plus 700. Clearly very high. Is that something you could restructure now and get a lower rate? And if not, what are the gating factors in terms of time and sort of cash levels or pay-down levels or financial results to get there?

[Joseph T. Lower, Office Depot, Inc.]

Chris, thanks for the question. As we have communicated as early back as May at Investor Day, we are continuing to look at the structure and the terms of the term loan. It's clearly something we're going to be looking at. As we've mentioned, a key anniversary date is coming up with the one-year anniversary, which changes the repurchase price, and so that is something we're going to be looking at in the fourth quarter. And, clearly, as I mentioned in my comments, one of our priorities for improving both the P&L and the balance sheet.

[Christopher Horvers, JPMorgan Securities LLC]

I got you. And then, I guess, any sort of thoughts on where that rate might go to, or sort of what comparable – what's sort of the comparable rate if you can refinance it?

[Joseph T. Lower, Office Depot, Inc.]

Yeah, I'm not comfortable speculating at this point, but you should assume that we will work and endeavor to improve the rate from where we are today, without saying too much more.

[Christopher Horvers, JPMorgan Securities LLC]

Got it. And then in terms of maybe you've seen improvements in BSD organic versus the last quarter and North American Retail comps actually deteriorated. So could you give us any color in terms of cadence during the quarter? Or how you're thinking about the outlook for the organic BSD growth in 4Q in Retail comp?

[Gerry P. Smith, Office Depot, Inc.]

Obviously, we've raised our commitment and guidance today for 2018. We have continued momentum on all the improvements. Steve and his team and our adjacency group under (01:02:09) and the good work our eCommerce team have done under Natalie Malaszenko, those will continue. And so we're bullish on continuing that trend and continue to grow organically. And let's be clear, we're going to continue to look at and make first buy of small regional players to get more supply chain distribution and customer relationships. And our federation strategy has been very successful, and those companies are growing organically also.

So we think we have the sales vision in place, and Steve and the team are committed to drive that success, and Natalie and eCommerce team as well. So I'm very optimistic we'll continue. And, again, the sales growth engine is working, and we're going to continue to grow that, and we're going to grow it next year. And I'm very, very proud of this team, the fact that a year-and-a-half ago, no one would have thought we could grow this business again, and no one would have thought we'd come out with growing in 2019 as well. And we're going to do that, and we're going to – growing organically first time in over a decade is a big, big statement, and we're really proud of the team, and we're going to continue that.

[Christopher Horvers, JPMorgan Securities LLC]

And then my last question is if you look at the division profitability, Retail and BSD were down this quarter relative to last year. The Corporate and Other line actually was also improved $4 million. By our math, it looks like it was about $18 million, down $4 million year-over-year, and in the first half that number was $39 million and $33 million. So could you help us understand what's driving that variability in that line? And how are you thinking about that line in the fourth quarter and on a go-forward basis?

[Joseph T. Lower, Office Depot, Inc.]

Yeah. So, you do have variations related to both the combination of compensation matters as well as tax-related matters that kind of come and go per quarter. If you look at an annual basis, though, as we said, it's somewhere between $100 million and $110 million but it often fluctuates between quarters just as certain events are recognized.

[Christopher Horvers, JPMorgan Securities LLC]

Got it. Okay. So that means that would suggest that the fourth quarter, that line should be down year-over-year as well?

[Joseph T. Lower, Office Depot, Inc.]

Approximately.

[Christopher Horvers, JPMorgan Securities LLC]

All right. Okay. Thanks very much.

[Operator]

That concludes the Q&A session for today. I will now turn the call back over to Office Depot's CEO, Gerry Smith, for any closing remarks.

[Gerry P. Smith, Office Depot, Inc.]

I just want to thank my team for an outstanding and strong quarter. Our sales and cash engines are working. And thank you for the participants for joining us today and your outstanding questions. We'll see you in 90 days. Thank you very much. Have a great day.

[Operator]

Thank you for your participation. This concludes today's call. You may now disconnect.