ITEM 1. BUSINESS
Staples, Inc. ("Staples" or "the Company") pioneered the office products superstore concept and is a leading office products distributor with a total of 742 retail stores located in the United States, Canada, the United Kingdom and Germany as of January 31, 1998, in addition to a catalog business and contract stationer operations. The Company's executive offices are located at One Research Drive, Westborough, Massachusetts 01581 (telephone: (508) 370-8500). The Company was organized in November 1985 and is incorporated in the State of Delaware.
BUSINESS STRATEGY
The Company views the office products market as a large diversified market for office supplies and equipment, business machines and computers, and various business services. Although there are no clear demarcations among segments, the Company targets four principal end-user groups: consumers and home offices; small businesses and organizations with fewer than 50 office workers; medium-size businesses and organizations with more than 50 office workers; and large businesses with more than 1,000 office workers. The Company's ability to address all four major end-user groups increases and diversifies its available market opportunities, increases awareness of the Staples name among customers in all four end-user groups (who often shop across distribution channels) and allows the Company to enjoy a number of important economies of scale. These include increased buying power, enhanced efficiencies in distribution and advertising, and improved capacity to leverage certain general and administrative functions.
The Company effectively reaches different sectors of the office products market through different channels of distribution designed to be convenient to each targeted market sector. Specifically, in-store operations seek to address the retail needs of customers, while the Company's Contract and Commercial division focuses on customers who desire delivery of their office products and other specialized services.
NORTH AMERICAN SUPERSTORES
Staples' North American retail operations, consisting of 685 stores as of January 31, 1998, are the core business of the Company, generating a substantial majority of its sales and profits. The Company's retail operations focus on serving the needs of customers primarily in the consumer, home office and small business segments of the office products market.
Superstores. The Company's North American superstores are located in 32 states, the District of Columbia and nine Canadian provinces in both major metropolitan markets and smaller outlying markets. The Company's current superstore prototype is approximately 24,000 square feet and offers about 8,000 different stock keeping units ("SKUs"). The Company's strategy for its North American superstores focuses on four key objectives: (i) providing superior customer value through a combination of broad product selection, everyday low prices, outstanding customer service and convenient locations; (ii) increasing the Company's presence in targeted markets by adding new superstores and achieving economies of scale in most of the major markets where it competes; (iii) reducing operating costs to the lowest level consistent with providing quality merchandise and service; and (iv) offering a comfortable, easy to shop store environment with skilled sales associates available to assist the customer.
Express Stores. In select urban markets, the Company operates a smaller store format, "Staples Express", which offers a more focused assortment of products. These smaller stores give the Company the opportunity to meet the office supply needs of customers in a store format that is efficient and economical in an urban environment. Staples Express stores range from approximately 6,000 to 10,000 square feet in size, and generally stock about 6,000 different SKUs.
CONTRACT AND COMMERCIAL
The Company's Contract and Commercial division is comprised of two principal operations: the Company's catalog business, operating under the name "Staples Direct", and the Company's contract stationer business, operating under the names "Staples National Advantage" and "Staples Business Advantage".
Staples Direct. Launched in 1990, Staples Direct, the Company's direct mail catalog business, reaches all targeted segments of the office products market seeking the convenience of telephone ordering and free next day delivery for orders over $50. Delivery orders are shipped from the Company's delivery distribution centers and are distributed through dedicated delivery hubs. In some markets, the Company also delivers products directly from its retail stores. The Company markets Staples Direct through both direct mail catalogs and a sales force primarily focused on generating new accounts. The Company recently expanded Staples Direct into and has begun catalog operations in Canada, United Kingdom and Germany.
Staples National Advantage and Staples Business Advantage. The Company's contract stationer operations focus primarily on serving the needs of medium- to large-size businesses that sometimes may seek more services than are provided by a traditional retail or mail order business, such as customized pricing, payment terms, usage reporting and the stocking of certain proprietary items. The Company's contract stationer business is divided into two segments. Staples National Advantage, which was established in February 1994 through the acquisition of National Office Supply Company, Inc., is a nationwide contract stationer business focused on selling to large multi-regional businesses. Staples Business Advantage focuses on selling to medium- and large-size regional companies and has the flexibility to handle smaller accounts. The Company initially established this business through acquisitions of regional contract stationers, and more recently has entered certain metropolitan markets through the expanded sales and distribution capabilities of Staples Business Advantage.
INTERNATIONAL
The Company believes that foreign markets provide additional growth opportunities. In 1991, the Company established its first international joint venture, "Business Depot", in Canada. Business Depot became a wholly-owned subsidiary of the Company in 1994 and operates as part of the Company's North American Superstores and Contract and Commercial divisions. The Company also became a partner in two overseas office products superstore joint ventures operating in the United Kingdom under the name "Staples UK" and in Germany under the name "MAXI-Papier-Markt-GmbH" ("MAXI-Papier"). In May 1997, the Company increased its ownership interest in the Staples UK operations to 100% and in MAXI-Papier to approximately 92%. As of January 31, 1998, Staples UK operated 40 stores and MAXI-Papier operated 17 stores. MAXI-Papier recently began operating the German stores under the Staples brand name.
STRATEGIC INITIATIVES
The Company is focusing on numerous strategic priorities, with the objective of enhancing its position as a leading office products supplier.
Profitably Increase Retail Sales Per Store. The Company is devoting significant resources and efforts to profitably increase its retail sales per store. Initiatives in this regard include: expanding product selection across all key product categories; improving sales capabilities related to capital goods (such as copiers, fax machines, computers and furniture); enhancing business services; improving in-stock positions; improving customer service; increasing staffing levels and personnel training; expanding store size; and improving shopability and signage. Another key element of this strategy is the Company's ongoing store remodeling program. This continuing remodeling program incorporates the Company's improved Concept 97 store layout, lighting, signage and the overall shopping environment, and will conform existing stores to the new prototype to the maximum extent practicable.
Continue Rapid Growth in Staples Direct. The Company is implementing a number of actions to profitably grow its delivery business. These actions include: broadening the product offerings available for delivery; offering specialized, more focused marketing; expanding the distribution areas of catalogs; increasing the number of direct sales representatives; providing open account invoicing to large accounts; and increasing distribution capacity. The Company believes that Staples Direct's operations are also benefiting from the increased marketing and advertising undertaken in connection with its store sales growth strategy.
Continue Store Growth and Strengthen Infrastructure. The Company is continuing its store growth program. In fiscal year 1997, the Company opened 129 new stores in North America and one new store in Europe. In fiscal 1998, the Company intends to open approximately 155 stores in North America and 15 stores in Europe. The Company's store growth strategy follows a three-pronged approach: continuing the growth of its store network in existing markets; entering smaller markets, within both existing and new geographic areas; and entering major new markets. The Company believes that its centralized distribution strategy facilitates its aggressive store growth by enabling the Company to operate smaller stores than would otherwise be required, thus reducing the cost of both opening and operating new stores, while providing the same or better product selection as a larger, competitive store. To support this commitment, the Company is taking steps to strengthen its infrastructure, including its distribution capabilities.
Improve Productivity. The Company maintains its historical focus on being a low cost operator and believes that it has significant opportunities to reduce costs as a percentage of sales. The Company believes that its future expansion will enable it to leverage certain fixed costs in store operations, marketing, distribution and administration. The Company is also seeking to enhance productivity through improvements in operating practices. The Company continually evaluates the productivity of its retail space and changes assortments, layouts and adjacencies as appropriate. The Contract and Commercial division also seeks to improve the efficiency and productivity of its distribution network.
Improve Customer Service. The Company has increased staffing levels in stores and delivery operations and made other investments to provide better customer service. Starting in 1995, the Company initiated a corporate-wide CARE program designed to empower associates to exceed customer expectations for service by providing "great service, every day, every way". The Company also expanded its "mystery shopper program" in which outside representatives evaluate customer service multiple times per year per store and has tied a portion of incentive compensation to achievement of customer satisfaction goals.
PRODUCTS AND PURCHASING
PRODUCTS
The Company's current North American superstore prototype stocks over 8,000 brand name and private label office products in each retail location, including office supplies, business machines, computers and related products, office furniture, and other business-related products. The Company tailors its product mix to meet the needs of its customers by regularly evaluating sales and profit performance for each of its SKUs. In order to minimize unit costs and selling prices, the Company sells most products in multi-unit packages. The lot sizes are designed to be large enough to be cost effective without being burdensome to the Company's small business customers.
The Company guarantees low prices to its customers and will not only match competitive prices but will also pay 55% of the price difference (up to $55) as a credit towards future purchases. The Company continuously compares its pricing against other discount office supply stores, local stationers, nearby warehouse clubs, mass merchants, computer superstores, consumer electronics retailers and mail order stationers to ensure that the strategy of maintaining everyday low prices is achieved.
The Company also offers its customers an array of services. Customers may place orders by telephone for delivery or for customer pickup. Customers may pay with MasterCard, Visa, American Express, Discover, or Staples private label credit card, in addition to check or cash. The Company also offers customers an option to lease business machines and computers through a third party lessor with varying terms. The Company offers high-speed and self-service copying, overnight mailing, faxing and other print services for its customers. The Company's return policy entitles customers to return all goods, except computers, printers and software, in original packaging within 30 days after the date of sale for a full refund; computers and printers must be returned within 14 days to obtain a full refund. Software packages must be unopened to obtain a full refund within 30 days; open packages will be exchanged only for the same title.
The Company's Contract and Commercial division carries many of the same products that are sold in the retail stores. Staples Direct catalogs typically contain approximately 5,000 in-stock products; through a special orders catalog, customers are offered an additional 20,000 items. The contract stationer catalog typically offers approximately 6,000 products with unique pricing, billing and other services available to each customer.
The following table shows sales by each major product line as a percentage of total sales for the periods indicated:
PURCHASING AND VENDOR SELECTION
Staples selects its vendors based upon quality, price, delivery reliability and, where appropriate, customer brand recognition. The Company believes it is able to pursue this purchasing strategy with great effectiveness and at very attractive costs in large part because of its centralized distribution facilities. The Company can purchase in truckload quantities attractively priced high quality products from multiple vendors and thereby achieve substantial cost savings in each product category.
The Company offers several hundred private label items including copy paper, staplers, envelopes, mailing and shipping supplies, a variety of fastening supplies, chairs, computer accessories, calculators and diskettes. Through its global product sourcing program, the Company is able to procure private label products at lower cost than brand name products, without sacrificing quality.
Currently, the Company purchases products from several hundred active vendors worldwide. Management believes that competitive sources of supply are available for substantially all products it carries. The Company's buying and merchandising staff centrally performs all product purchasing and merchandise planning for stores with the assistance of integrated computer systems.
DISTRIBUTION
The Company operates centrally located distribution centers on the East and West coasts to service the majority of its replenishment and delivery requirements for its U.S. retail and catalog operations. The Company's contract stationer operations also utilize additional distribution centers that fulfill the unique needs of their customers. Most products are shipped from the Company's suppliers to the distribution centers for reshipment to Staples stores and delivery hubs, or are directly shipped to customers. The distribution centers employ computerized selection, just-in-time replenishment procedures and material handling equipment that help to minimize overall Company inventory levels while maintaining optimal in-stock positions at the store level. Product processing and ticketing are performed at the distribution center to improve labor efficiency and reduce cost. Products generally are delivered to Staples stores within 48 hours after the Company's automated replenishment system generates an order for the product based on daily point of sale information.
The Company believes its distribution centers provide it with significant labor, merchandise and inventory shrinkage savings by centralizing receiving and handling functions and by enabling the Company to purchase in full truckloads from suppliers. The Company believes that the reduction in the number of purchase orders and invoices processed results in significant administrative cost savings. The Company's centralized purchasing and distribution systems also permit store employees to spend more time on customer service and store presentation.
Since the distribution centers maintain backup inventory, in-store inventory requirements are reduced and the Company operates smaller gross square footage stores than would otherwise be required. Smaller store size reduces the Company's rental costs in the expensive markets in which it currently operates and allows the Company improved flexibility in locating stores more closely to its target customers.
The Company continues to enhance its distribution network to support its retail stores. The Company recently opened two new distribution centers: Hagerstown, Maryland (840,000 sq. ft.) in March 1997 and Killingly, Connecticut (310,000 sq. ft.) in January, 1998. In addition, the Company expects to open a 520,000 sq. ft. facility in Rialto, California in early 1999. These 3 new facilities are expected to replace a network of approximately 11 distribution centers formerly used to support U.S. retail operations.
MARKETING STRATEGY
The Company pursues a variety of marketing strategies to attract and retain target customers. These strategies include broad-based media advertising such as radio, television, newspaper circulars and print advertising as well as catalogs and a sophisticated direct marketing system. In addition, the Company markets to larger companies through a combination of direct mail catalogs, customized catalogs and a field sales force. The Company changes its level of marketing spending as well as the mix of media employed depending upon market, competitive and cost factors. This flexible approach allows the Company to optimize the effectiveness and efficiency of its marketing expenditures.
Through its store and catalog direct marketing system, the Company tracks the buying habits of many of its customers, measures the response rate to various catalog marketing and promotional efforts and responds to changes in purchasing patterns and customer demands. The customer database for the Company's direct marketing system is derived from a variety of sources, including Staples private label charge cards, Staples tax-exempt customer cards, and Staples delivery orders.
In 1997, the Company continued to invest in its nationally recognized television campaign and began to supplement its spot television schedule with network ads. This television advertising is designed to raise awareness of Staples and penetration levels for both the household and business customer segments across the country. In addition, the Company expanded its print advertising campaign in markets identified as having high incremental sales potential and developed additional print programs to support key product categories. The Company also entered into a naming rights agreement with L.A. Arena Company, LLC, which is designing a new state of the art entertainment complex in downtown Los Angeles. This agreement provides the Company with marketing, promotional and signage rights, community-based programs and various amenities in the STAPLES Center for the next 20 years. Finally, the Company continued to build and refine its loyalty program and top customer database in 1997 through its "Dividends" program, which rewards the top store and catalog customers with volume based rebates and a variety of other benefits.
STORE OPERATIONS AND TRAINING
STORE OPERATIONS
The Company strives to be the lowest cost operator of office products stores servicing its targeted customers. Staples seeks to create stores that appeal to its target customers for their broad selection, everyday low prices, convenience, shopability and helpful service. The Company's stores typically are open 91 hours (seven days) per week; minor variations exist in the European operations.
Staples retail stores display inventory according to a plan-o-gram that designates graphically the place each item in each section of the store is displayed and specifies the quantity to be stocked. Related items are typically grouped together for customer convenience. Store layouts are as uniform as the various facilities allow, so that products destined for stores can be picked at the distribution center to match store aisles.
Staples' computer systems replenish inventory levels for each SKU by store based on its rate of sale and variability in rate of sale. Sales and inventory levels are tracked by SKU at each store through the Company's point-of-sale system and are transmitted nightly to the Company's host computer. Reorders from the distribution center are processed so that inventory arrives at Staples stores on a just-in-time basis.
Stores are brightly lit and products are attractively displayed. Employees are available to consult on purchases, particularly in the Company's furniture, business machines and computer sections, where customers often need assistance in decision-making. A new store layout design was approved for all new stores and remodels in July, 1997. The new design, Concept 97, emphasizes technology sales, service and computer upgrades through the Staples Tech Center. Also included are enhanced product assortments in furniture, paper and office supplies. In the services category, Concept 97 promotes the new Staples Copy Center with enhanced services and, where market conditions warrant, expanded copy centers ranging from 1,300 square feet to 2,500 square feet. The Company will continue to rollout Concept 97 to all new stores and to varying degrees on future remodels. The Company's current store prototype is approximately 24,000 square feet, which allows for enhanced business services, product depth and capital goods sales. Where possible, the Company has expanded existing stores to fit the new format.
The Company has continued to make an investment in computer-based, multi-media training programs to upgrade staff selling skills and improve customer service at its retail stores and delivery operations. Much of the training targets sales of capital goods such as fax machines, copiers, furniture and computers. Additionally, the Company continues to increase its efforts to improve its in-stock position as well as expand the product depth in certain key categories in order to best serve its customers.
ASSOCIATES AND ASSOCIATE TRAINING
The Company places great importance on recruiting, training and providing the proper incentives for quality store level personnel. This includes building its store management organization from within. The Company recruits actively on college campuses and also hires talented individuals with experience in successful retail operations. Additionally, current associates are rewarded for recruiting new associates. A majority of the Company's store managers have been trained in the Company's management development program.
Management considers customer relations and its associates' knowledge of office products and office-related capital goods to be significant to its marketing approach and its ability to maintain customer satisfaction. New management trainees advance through the store management structure by taking on assignments in different areas as they are promoted. Store and telemarketing employees prepare for new assignments by studying training modules, including written manuals, video instruction and self-testing, which are prepared by the Company and others. These associates are trained in a number of areas, including, where appropriate, sales techniques, management techniques and product knowledge.
The Company offers eligible associates the opportunity to acquire equity in the Company through an employee stock purchase plan, and also grants stock options and restricted stock to certain of its associates as an incentive to attract and retain such associates.
As of January 31, 1998, the Company employed 16,213 full-time and 16,073 part-time employees.
EXPANSION STRATEGY
The Company's expansion strategy involves the establishment of a strong market position by increasing its presence in targeted metropolitan markets by operating a full network of stores, entering small markets and focusing growth in those markets where products can be cost effectively replenished through its distribution centers. The Company believes that a network of stores in a metropolitan market enhances profitability by leveraging marketing costs, distribution expense and supervision costs.
The Company currently plans to open approximately 155 stores in North America in fiscal 1998. Approximately 15 store openings are planned for the UK and Germany in fiscal 1998. The Company's growth strategy calls for continuing to increase its presence along both the East and West coasts of the United States as well as portions of the Southeast and Midwest regions. Additionally, the Company plans to expand into one or more major new markets per year as well as numerous smaller markets.
In determining where to open new stores, the Company evaluates the concentration of small- and medium-sized businesses and organizations, the number of home offices, household income levels, the availability of quality real estate locations, competitive factors and other factors. Ideally, stores are located on high-traffic arteries convenient to the targeted businesses and consumers, with parking adequate to support high sales volumes. While most of its stores have been located in conventional strip shopping centers, the Company has also successfully converted non-retail properties to Staples stores. Although the Company often leases second-use properties, it has also entered into ground leases where it plans to build a store or arranged to have landlords construct free-standing buildings to its specifications. In addition, the Company has on numerous occasions acquired lease rights from prior tenants. The Company believes that this flexibility in selecting sites will prove helpful as it seeks to locate additional stores in the difficult real estate markets in which it operates.
COMPETITION
The Company competes with a variety of retailers, dealers and distributors in the highly competitive office products market. The Company believes its customers choose among suppliers on the basis of price, breadth of selection, service and convenience.
The Company's target customers have historically been serviced by traditional office products dealers. The Company believes it has competed favorably against these dealers in the past because it generally offered larger discounts off catalog list prices than these dealers. In addition, the Company believes that its broad product line, depth of in-stock inventory and extended store hours offer it competitive advantages. Recently, however, some traditional office product dealers have lowered prices and increased their service levels to become more competitive with discount retailers.
The Company also competes in most of its geographic markets with other high-volume office supply chains that are similar in concept to the Company in terms of store format, pricing strategy, and product selection, including Office Depot, OfficeMax, and Office World as well as mass merchants, such as Wal-Mart, warehouse clubs, computer and electronics superstores, and other discount retailers. In addition, the Company's retail stores, as well as its delivery and contract business, compete with numerous mail order firms, contract stationer businesses and direct manufacturers. Such competitors have increased their presence in the Company's markets in recent years. Some of the Company's current and potential competitors in the office products industry are larger than the Company and have substantially greater financial resources. No assurance can be given that such increased competition will not have an adverse effect on the Company's business.
TRADEMARKS
The Company has registered the marks "Staples" and "Staples- The Office Superstore" on the Principal Register of the United States Patent and Trademark Office and the mark "Staples" in Canada, the United Kingdom and Germany.
ITEM 2.
ITEM 2. PROPERTIES
As of January 31, 1998 the Company operated 742 superstores in 32 states, the District of Columbia, 9 provinces in Canada, 9 regions in the United Kingdom and 5 states in Germany. The Company also operates 34 distribution centers. The following table sets forth the locations of the Company's facilities.
Most of the existing stores are leased by the Company with initial lease terms expiring between 1998 and 2023. In most instances, the Company has renewal options at increased rents. Leases for 171 of the existing stores provide for contingent rent based upon sales.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is not party to any material legal proceedings.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's security holders during the last quarter of the fiscal year ended January 31, 1998.
PART II -------
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is traded on the Nasdaq National Market under the symbol "SPLS".
At January 31, 1998, the number of holders of record of the Company's Common Stock was 10,403.
The following table sets forth for the periods indicated the high and low sale prices per share of the Common Stock on the Nasdaq National Market, as reported by Nasdaq, retroactively adjusted for the three-for-two stock split in January, 1998.
The Company has never paid a cash dividend on its Common Stock. The Company presently intends to retain earnings for use in the operation and expansion of its business and, therefore, does not anticipate paying any cash dividends in the foreseeable future. In addition, the Company's revolving credit agreement restricts the payment of dividends.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The information required by this Item is attached as APPENDIX A.
ITEM 7.
ITEM 7. APPENDIX B
MANAGEMENT'S DISCUSSION AND ANALYSIS of Financial Condition and Results of Operations
RESULTS OF OPERATIONS ................................................................................ COMPARISON OF FISCAL YEARS ENDED JANUARY 31, 1998, FEBRUARY 1, 1997, AND FEBRUARY 3, 1996
GENERAL. During the fiscal year ended January 31, 1998, the Company acquired Kingfisher PLC interests in Staples UK and MAXI-Papier-Markt-GmbH ("MAXI-Papier"). Staples UK and MAXI-Papier operate a chain of office products superstores in the UK and Germany, respectively. As a result of these acquisitions, the Company's ownership interest of Staples UK increased to 100% and its ownership interest in MAXI-Papier increased to approximately 92%. The cash purchase price of approximately $57 million was generated through additional borrowings under the Company's existing revolving credit facility. The transactions were accounted for in accordance with the purchase method of accounting and accordingly, the results of operations of Staples UK and MAXI-Papier have been included in the Company's consolidated financial statements since May, 1997. The excess of the purchase price has been recorded as goodwill and is being amortized on a straight line basis over 40 years. Prior to May 1997, the operating results of Staples UK and MAXI-Papier were accounted for under the equity method.
The earnings per share amounts prior to 1997 have been restated as required to comply with Statement of Financial Accounting Standards No. 128, Earnings Per Share ("FAS 128"). For further discussion of earnings per share and the impact of FAS 128, see the Notes to the Consolidated Financial Statements beginning on Page C-7.
The fiscal years ended January 31, 1998 and February 1, 1997 consisted of 52 weeks, while the fiscal year ended February 3, 1996 consisted of 53 weeks.
SALES. Sales increased 31% to $5,181,035,000 in the fiscal year ended January 31, 1998 from $3,967,665,000 in the fiscal year ended February 1, 1997. Sales increased 29% in the fiscal year ended February 1, 1997 from $3,068,061,000 in the fiscal year ended February 3, 1996; excluding the additional week in the fiscal year ended February 3, 1996, sales increased 32%. The growth in each year was attributable to an increase in the number of open stores, increased sales in existing stores and increased sales in the delivery and contract stationer segments. In addition, sales for the fiscal year ended January 31, 1998 include the consolidation of Staples UK and MAXI-Papier. Comparable store and delivery hub sales for the fiscal year ended January 31, 1998 increased 10% over the fiscal year ended February 1, 1997; comparable sales in the contract stationer segment increased 12% over the year ended February 1, 1997. Comparable store and delivery hub sales for the year ended February 1, 1997 increased 14% over the year ended February 3, 1996; comparable sales in the contract stationer segment increased 17% over the year ended February 3, 1996. As of January 31, 1998, February 1, 1997, and February 3, 1996, the Company had 742, 557, and 443 open stores, respectively. The January 31, 1998 total includes 130 stores opened and one store closed during the twelve months ended January 31, 1998 and 56 stores that were acquired in the UK and Germany as a result of the acquisitions of Staples UK and MAXI-Papier.
GROSS PROFIT. Gross profit was 24.1%, 23.8%, and 22.9% of sales for the fiscal years ended January 31, 1998, February 1, 1997, and February 3, 1996, respectively. The increase in gross profit rate for the years ended January 31, 1998 and February 1, 1997 was primarily due to improved margins in the retail and delivery business segments due to lower product costs from vendors as a result of increased purchase discounts and changes in product mix, as well as the leveraging of fixed distribution center and delivery costs over a larger sales base. This was partially offset by decreases in the margin rates in the retail store segment due to price reductions as well as an increase in the sales of computer hardware (CPU's and laptops), which generate a lower margin rate than other categories, to 8.4% of total sales for the year ended January 31, 1998 from 7.7% in the year ended February 1, 1997 and 7.5% in the year ended February 3, 1996.
OPERATING AND SELLING EXPENSES. Operating and selling expenses, which consist of payroll, advertising and other operating costs, were 15.1%, 15.0%, and 14.5% of sales for the fiscal years ended January 31, 1998, February 1, 1997, and February 3, 1996, respectively. The increase as a percentage of sales for the years ended January 31, 1998 and February 1, 1997 was primarily due to planned increases in advertising and circulars as well as increases in store labor and costs incurred for the Company's store remodel program in which significant investments have been made in store layouts and signing to improve shopability and enhance customer service. In addition, operating and selling expenses for the year ended January 31, 1998 include the results of Staples UK and MAXI-Papier, which have higher costs as a percentage of sales due to their early stage of development. These increases were partially offset by reduced costs resulting from the Company's ability to leverage fixed store payroll expenses and other fixed store operating costs as store sales have increased.
Staples UK and MAXI-Papier store expenses are higher than most other Staples stores as a result of their earlier stage of development. While most store expenses vary proportionately with sales, there is a fixed cost component. Because new stores typically generate lower sales than the Company average, the fixed cost component results in higher store operating and selling expenses as a percentage of sales in these stores during their start-up period. During periods when new store openings as a percentage of the base are higher, store operating and selling expenses as a percentage of sales may increase. In addition, as the store base matures, the fixed cost component of operating expenses is leveraged over an increased level of sales, resulting in a decrease in store operating and selling expenses as a percentage of sales. The Company's strategy of continuing to add stores to many existing markets can result in some new stores attracting sales away from existing stores.
PRE-OPENING EXPENSES. Pre-opening expenses relating to new store openings, which consist primarily of salaries, supplies, marketing and occupancy costs, are expensed by the Company as incurred and therefore fluctuate from period to period depending on the timing and number of new store openings. Pre-opening expenses averaged $73,000, $72,000, and $58,000 per store for the stores opened in the fiscal years ended January 31, 1998, February 1, 1997, and February 3, 1996, respectively. The increase from the fiscal year ended February 3, 1996 was due primarily to increased marketing expenses as well as higher costs incurred in the initial shipment of products from the distribution centers to new stores.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses as a percentage of sales were 3.5%, 3.4%, and 3.3% in the years ended January 31, 1998, February 1, 1997, and February 3, 1996, respectively. The increase as a percentage of sales for the fiscal years ended January 31, 1998 and February 1, 1997 was primarily due to significant investments in the Company's information systems' staffing and infrastructure, which the Company believes will reduce costs as a percentage of sales in future years. In addition, general and administrative expenses for the fiscal year ended January 31, 1998 include the results of Staples UK and MAXI-Papier, which have higher general and administrative costs as a percentage of sales; as their store base matures overhead expenses should decrease as a percentage of sales. This overall increase in general and administrative costs were partially offset by the Company's ability to increase sales without proportionately increasing overhead expenses in its core retail business.
INTEREST AND OTHER EXPENSE, NET. Net interest expense totaled $23,053,000, $19,887,000, and $15,815,000 in the fiscal years ended January 31, 1998, February 1, 1997, and February 3, 1996, respectively. The increase in the fiscal years ended January 31, 1998 and February 1, 1997 was primarily due to increased borrowings, which funded: the increase in store inventories related to new store openings, expanded product assortment, and improvements in in-stock levels; the acquisition of fixed assets for new stores opened and remodeled; continued investments in the information systems and distribution center infrastructure; and additional investments in Staples UK and MAXI-Papier as well as the purchase of them during the fiscal year ended January 31, 1998.
MERGER-RELATED COSTS. During the fiscal year ended January 31, 1998, the Company charged to expense certain non-recurring costs consisting primarily of legal, accounting, transaction related costs, such as filing fees, and consulting fees incurred in connection with the proposed merger with Office Depot, Inc.
EQUITY IN LOSS OF AFFILIATES. Equity in Loss of Affiliates is comprised of the Company's share of the losses incurred by Staples UK and MAXI-Papier before the Company's acquisition of these entities in May, 1997. Prior to the acquisitions, the Company's investments in Staples UK and MAXI-Papier were accounted for using the equity method which resulted in the Company's share of losses from operations being included in Equity in Loss of Affiliates. Equity in Loss of Affiliates totaled $5,953,000, $11,073,000, and $12,153,000, in the fiscal years ended January 31, 1998, February 1, 1997, and February 3, 1996, respectively. The decrease in the Equity in Loss of Affiliates for the fiscal year ended January 31, 1998 was due to the acquisition of Staples UK and MAXI-Papier on May 6, 1997 and May 7, 1997. As a result of the acquisitions, the Company's ownership interest of Staples UK increased to 100% and its ownership of MAXI-Papier increased to approximately 92%. The transactions were accounted for in accordance with the purchase method of accounting and accordingly, the results of operations of Staples UK and MAXI-Papier have been included in the Company's consolidated financial statements since the respective acquisition dates.
INCOME TAXES. The provision for income taxes as a percentage of pre-tax income was 38.5% for each of the fiscal years ended January 31, 1998, February 1, 1997 and February 3, 1996.
LIQUIDITY AND CAPITAL RESOURCES ................................................................................
The Company traditionally uses a combination of cash generated from operations and debt or equity offerings to fund its expansion and acquisition activities. During the fiscal years ended January 31, 1998, February 1, 1997 and February 3, 1996, the Company also utilized its revolving credit facility to support its various growth initiatives.
The Company opened 130 stores, 115 stores, and 94 stores in the fiscal years ended January 31, 1998, February 1, 1997 and February 3, 1996, respectively, and closed one store in each of these fiscal years. In addition, in the fiscal year ended January 31, 1998, 56 stores were added as a result of the acquisition of Staples UK and MAXI-Papier. As the store base matures and becomes more profitable, cash generated from store operations is expected to provide a greater portion of funds required for new store inventories and other working capital requirements. Sales generated by the contract stationer business segment are made under regular credit terms, which requires that the Company carry its own receivables from these sales. The Company also utilized capital equipment financings to fund current working capital requirements.
As of January 31, 1998, cash, cash equivalents, and short-term investments totaled $357,904,000, an increase of $251,775,000 from the February 1, 1997 balance of $106,129,000. The principal sources of funds were primarily cash from operations, an increase in accounts payable and accrued expenses of $320,527,000, which financed the increase in merchandise inventory of $227,037,000 related to new store openings, expanded product assortment and improvements in in-stock levels; and cash provided by financing activities of $182,851,000 due primarily to the issuance of $200,000,000 of senior notes on August 12, 1997. These sources were partially offset by the acquisition of property and equipment of $183,133,000 and cash used in the acquisition of Staples UK and MAXI-Papier, net of cash acquired, of $79,325,000.
The Company expects to open approximately 170 stores during fiscal 1998. Management estimates that the Company's cash requirements, including pre-opening expenses, leasehold improvements and fixtures (excluding store inventory financed under vendor trade terms), will be approximately $1,400,000 for each new store (excluding the cost of any acquisitions of lease rights). Accordingly, the Company expects to use approximately $238,000,000 for store openings during this period. In addition, the Company plans to continue to make investments in information systems, distribution centers and store remodels to improve operational efficiencies and customer service, and may expend additional funds to acquire businesses or lease rights from tenants occupying retail space that is suitable for a Staples store. The Company expects to meet these cash requirements through a combination of operating cash flow and borrowings from its existing revolving line of credit.
The Company issued $200,000,000 of senior notes (the "Notes") on August 12, 1997 with an interest rate of 7.125% payable semi-annually on February 15 and August 15 of each year commencing on February 15, 1998. Net proceeds of approximately $198,000,000 from the sale of the Company's Notes were used for repayment of indebtedness under the Company's revolving credit agreement and for general working capital purposes, including the financing of new store openings, distribution facilities and corporate offices.
Effective November 13, 1997 the Company entered into a new revolving credit facility, effective through November 2002, with a syndicate of banks which provides up to $350,000,000 of available borrowings. Borrowings made pursuant to this facility will bear interest at either the lead bank's prime rate, the federal funds rate plus 0.50%, the LIBOR rate plus a percentage spread based upon certain defined ratios, a competitive bid rate, or a swing line loan rate. This agreement, among other conditions, contains certain restrictive covenants including net worth maintenance, minimum fixed charge interest coverage and limitations on indebtedness, sales of assets, and dividends. As of January 31, 1998, no borrowings were outstanding under the revolving credit agreement. MAXI-Papier also has a revolving credit facility under which $8,746,000 was outstanding as January 31, 1998. Total cash, short-term investments and available revolving credit amounts totaled $733,916,000 as of January 31, 1998.
The Company expects that its current cash and cash equivalents and funds available under its revolving credit will be sufficient to fund its planned store openings and other recurring operational cash needs for at least the next twelve to eighteen months. The Company is continually evaluating financing possibilities, and it may seek to raise additional funds through any one or a combination of public or private debt or equity-related offerings, dependent upon market conditions, or through additional commercial bank debt arrangement.
INFLATION AND SEASONALITY
While inflation or deflation has not had, and the Company does not expect it to have, a material impact upon operating results, there can be no assurance that the Company's business will not be affected by inflation or deflation in the future. The Company believes that its business is somewhat seasonal, with sales and profitability slightly lower during the first and second quarters of its fiscal year.
FUTURE OPERATING RESULTS
Factors that could affect the Company's future operating results include, without limitation, the following:
The Company operates in a highly competitive marketplace, in which it competes with a variety of retailers, dealers and distributors. The Company competes in most of its geographic markets with other high-volume office supply chains that are similar in concept to the Company in terms of store format, pricing strategy and product selection, such as Office Depot, OfficeMax, and Office World as well as mass merchants, such as Wal-Mart, warehouse clubs, computer and electronics superstores, and other discount retailers. In addition, the Company's retail stores, as well as its delivery and contract business, compete with numerous mail order firms, contract stationer businesses and direct manufacturers. Such competitors have increased their presence in the Company's market in recent years. Some of the Company's current and potential competitors in the office products industry are larger than the Company and have substantially greater financial resources. No assurance can be given that competition will not have an adverse effect on the Company's business.
An important part of the Company's business plan is an aggressive store growth strategy. The Company opened 130 stores in the United States, Canada and Europe in fiscal 1997 and plans to open
approximately 170 new stores in fiscal 1998. There can be no assurance that the Company will be able to identify and lease favorable store sites, hire and train employees, and adapt its management and operational systems to the extent necessary to fulfill its expansion plans. The failure to open new stores in accordance with its growth plans could have a material adverse impact on the Company's future sales and profits. Moreover, the Company's expansion strategy is based in part on the continued addition of new stores to its store network in existing markets to take advantage of economies of scale in marketing, distribution and supervision costs; however, this can result in the "cannibalization" of sales of existing stores. In addition, there can be no assurance that the new stores opened by the Company will achieve sales or profit levels commensurate with those of the Company's existing stores.
The Company has experienced and may experience in the future fluctuations in its quarterly operating results. Moreover, there can be no assurance that Staples will continue to realize the earnings growth experienced over recent years, or that earnings in any particular quarter will not fall short of either a prior fiscal quarter or investors' expectations. Factors such as the number of new store openings (pre-opening expenses are expensed as incurred, and newer stores are less profitable than mature stores), the extent to which new stores "cannibalize" sales of existing stores, the mix of products sold, pricing actions of competitors, the level of advertising and promotional expenses, seasonality, and one-time charges associated with acquisitions or other events could contribute to this quarterly variability. In addition, the Company's expense levels are based in part on expectations of future sales levels, and a shortfall in expected sales could therefore result in a disproportionate decrease in the Company's net income.
The Company's business, including sales, number of stores and number of employees, has grown dramatically over the past several years. In addition, the Company has consummated a number of significant acquisitions in the last few years, and may make additional acquisitions in the future. This internal growth, together with the acquisitions made by the Company, have placed significant demand on the management and operational systems of the Company. To manage its growth effectively, the Company will be required to continue to upgrade its operational and financial systems, expand its management team and increase and manage its employee base.
The Company has a presence in international markets in Canada and through its recently acquired operations in Germany and the United Kingdom, and may seek to expand into other international markets in the future. The Company's operations in foreign markets are subject to risks similar to those affecting its U.S. stores, in addition to a number of additional risks inherent in foreign operations, including local customs and competitive conditions, and foreign currency fluctuations. Staples' European operations are currently unprofitable, and there can be no assurance that they will become profitable.
The Company currently expects that its current cash and cash equivalents and funds available under its revolving credit facility will be sufficient to fund its planned store openings and other operating cash needs for at least the next twelve to eighteen months. However, there can be no assurance that the Company will not require additional sources of financing prior to such time, as a result of unanticipated cash needs or opportunities, an expanded growth strategy or disappointing operating results. There also can be no assurance that the additional funds required by the Company, whether within the next twelve to eighteen months or thereafter, will be available to the Company on satisfactory terms.
YEAR 2000
The Company has conducted a comprehensive review of its internal computer systems and applications to identify those that might be affected by the year 2000 issue and has developed an implementation plan to resolve the year 2000 issue. The Company is in the process of correcting or replacing those systems and applications which are not currently year 2000 compliant. The Company believes it will be able to modify or replace its affected systems and applications in time to avoid any material detrimental impact on its operations.
The Company will incur internal staff costs as well as consulting and other expenses related to infrastructure and facilities enhancements necessary to prepare its systems and applications for the year 2000 issue. The preliminary expense estimate for year 2000 corrective and replacement activities ranges from $15 to $20 million, a portion of which would have been incurred as part of normal system and application upgrades.
It is anticipated that all year 2000 compliance efforts will be complete by mid fiscal year 1999, including testing. However, if such modifications and conversions are not completed in a timely manner, the year 2000 issue may have a material impact on the operations of the Company. The Company is also working to ensure that products purchased at Staples, as well as services utilized by Staples, will be year 2000 compliant.
ITEM 7A.