California Turns into Land of Nightmares for Office Depot

Last Updated Aug 26, 2010 2:43 PM EDT

Office Depot's warm California sun has been obliterated by the smog of a burnt over economy, and things could get worse.

The company's business in the Golden State is anything but, and the outlook will darken considerably if it loses a key contract with Los Angeles County.

For Office Depot (ODP), the recession hasn't really ended, in large part because conditions in California remain rough. The problem starts with the general economy in a state where the chain has about 150 locations. That number represents about 13 percent of Office Depot's total stores in the U.S., so when California hurts, so does the retailer. Results in California were sufficiently depressed to ensure that Office Depot's comparable store sales, those in locations open for at least a year, remained in the negative range, down about one percent in the first quarter, the company announced Monday.

Hard-pressed consumers and sagging small businesses are only part of Office Depot's California tribulations. The retailer does a significant business with the state and local governments and, with their coffers near bare, fewer employees are on the job, less work is getting done and fewer office products and services are being purchased. Steven Schmidt, president of the company's business services division, assessed the situation in a conference call transcribed by SeekingAlpha, saying:

With the budget deficit and government mandated three day per month furloughs for state employees in place, it looks like our business in California could be affected for an extended period. The furloughing not only impacts our public sector business, it also has a negative trickle down affect on small business customers as well.
Despite the scope of its dilemma, Office Depot's biggest concern at the moment is confined to relatively small if significant state sector, Los Angeles County.

Office Depot doesn't just sell government workers products through in stores. It participates in co-operative called U.S. Communities, which facilitates a contract business selling goods and services to government entities around the United States. The retailer's L.A. business is particularly significant â€"- one analyst estimated it at $500 million -- and the company's contract with the county is up this year.

While expressing optimism about the company's ability to retain the contract, Schmidt conceded that Office Depot had a struggle ahead of it, as many companies want the L.A. County business. He said:

Given the economic situation the state of California is in, I mean, they're doing everything they humanly can do to reduce their cost base, and they're relooking at every piece of their business across every agency across California, and no different with L.A. County. They want to put it out to bid and time will tell relative to our ability to retain it--We'll just have to see how the bid process works its way through.
On top of everything else, in 2008 a whistle-blower emerged to report that Office Depot was overcharging some municipalities that had contracted with it. The company blamed the whistle-blowing employee for the overcharges, but the aggrieved parties naturally went after the retailer for restitution. Among other parties, Office Depot had to pay the state of California $2.5 million, and it lost contracts with San Francisco and Lee County, Fla. -â€" both determined they had overpaid the company -- totaling $18 million, according to a published report. Office Depot's main competition, Staples (SPLS), got those.

Given recent history, it might seem as if regaining the L.A. contract would be particularly tough. However, Office Depot's travails make keeping the contract all the more important to it, and the company promised to be extremely aggressive in holding onto that business. So, a contract renewal is likely, but so is one with a much lower profit margin

Office supply specialists already face a lingering problems. The tight credit market continues to particularly hurt their small business customers. And their most direct competitors include warehouse club, originally devised to serve small businesses, that have been doing well in the economic downturn and, so, have money to spend on promotions and other incentives to commercial customers.

Office Depot's business turned out to be particularly exposed to just the recession the U.S. tumbled into two years ago, so it faces a particularly difficult struggle against the left over malaise. And can't turn to California dreaming for solace.