Boise Cascade Office Products

Boise Cascade Office Products
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Results of Operations
1997 COMPARED WITH 1996

Net sales in 1997 increased 31% to $2.6 billion, from $2.0 billion in 1996. The growth in sales resulted from acquisitions and internal growth. Same-location sales increased 14%. Sales growth was constrained by lower paper prices. Holding paper prices constant, same-location sales increased 17%. Businesses acquired during 1996 had sales in 1996 of approximately $332 million and sales in 1997 of $524 million. The increase is due to the implementation of our business model in these acquisitions, including increasing sales to our national accounts and broadening product offerings, as well as a full calendar year of ownership in 1997.

Cost of sales, which includes the costs of merchandise sold, delivery, and occupancy, increased in 1997 to $1.9 billion, which was 74.8% of net sales. This compares with $1.5 billion, or 73.9% of net sales, in 1996. The 0.9% decrease in gross margin resulted in part from continued competitive pressures on gross margins, especially in national accounts. Additionally, in the first half of 1996, paper costs to us were declining rapidly from the peak reached late in 1995, which raised our gross margin in the first half of 1996. In 1997, paper costs were more stable but significantly lower, constraining our 1997 margins. We believe that the increasingly competitive nature of the industry and the increasing price sensitivity of customers will continue to put downward pressure on gross margins. In addition, changes in our product mix or marketing strategy could, from time to time, affect gross margins. For example, we continue to increase our sales of computer-related consumables, a product line that had significantly lower gross margins and associated operating expenses in 1997 than our more traditional office products line.

Operating expense was 20.6% of net sales in 1997, compared with 21.0% in 1996. This decrease resulted in part from leveraging expenses across a larger revenue base and from specific initiatives to increase efficiency, for example, by increasing central procurement and integrating distribution programs. Within the operating expense category, selling and warehouse operating expense was 18.6% of net sales in 1997, compared with 18.9% in 1996. The decrease was a result of efficiencies gained from our centralized call centers and the centralization of our inventory rebuying function. Corporate general and administrative expense declined to 1.6% of net sales in 1997 from 1.7% in 1996, because we were able to spread the cost of centralized functions over our higher revenues. Goodwill amortization was 0.4% of net sales in 1997 compared with 0.3% in 1996. The increase between 1996 and 1997 resulted from our acquisition activity in 1996 and 1997.

As a result of the factors discussed above, income from operations was $119 million in 1997, an 18% increase over $101 million in 1996. Our operating margin decreased to 4.6% from 5.1% of net sales in 1996.

Interest expense was $20 million in 1997 compared with $8 million in 1996. The increase resulted from debt incurred in conjunction with our acquisition and capital spending programs.

Income tax expense was $43 million in 1997 compared with $38 million in 1996. The increase resulted from our higher taxable income in 1997 and from an increase in our effective tax rate. Our effective tax rate increased to 43% in 1997 from 41% in 1996, primarily as a result of increased nondeductible goodwill and foreign income taxed at a higher rate.

Net income increased 3% to $57 million, or 2.2% of net sales, compared with $55 million, or 2.8% of net sales, in 1996.

1996 COMPARED WITH 1995
Net sales in 1996 increased 51% to $2.0 billion, from $1.3 billion in 1995. The growth in sales resulted primarily from acquisitions. Businesses acquired during 1995 had sales in 1995 of $90 million. Sales for the 1995 acquisitions increased to $264 million for 1996 because they were owned for the full calendar year and we had begun to implement our business model in these acquisitions, including increasing sales to national accounts and broadening product offerings. Businesses acquired during 1996 had sales in 1996 of $332 million. Excluding the incremental effect of the 1995 and 1996 acquisitions, net sales increased $200 million, primarily as a result of growth in national account sales, our broader product offering, and growth in direct marketing sales.

Cost of sales, which includes the costs of merchandise sold, delivery, and occupancy, increased in 1996 to $1.5 billion, which was 73.9% of net sales. This compares with $981 million, which represented 74.5% of net sales, in 1995. The 0.6% increase in gross margins for 1996 compared with 1995 resulted primarily from our acquisition of Neat Ideas, a direct marketing company based in the United Kingdom, and Grand & Toy Limited, one of Canada's largest contract stationers. Both of these companies have gross margins which are higher than the average gross margin of our other business. In addition, our average gross margin on office paper sales was higher in 1996 than in 1995, when we experienced difficulty in passing through cost increases early in the year.

Operating expense was 21.0% of net sales in 1996, compared with 20.2% in 1995. This increase was primarily the result of our increased presence in direct marketing and the international contract stationer business, both of which have higher operating expenses than the average of our other business. Sharply lower paper prices in 1996 also reduced overall revenue growth, negatively impacting our ability to leverage our operating expenses. Within the operating expense category, selling and warehouse operating expense was 18.9% of net sales in 1996, compared with 18.2% in 1995. In addition to the factors discussed above, in 1996 we added more than 40 associates to our sales force dedicated to computer-related products; started up a centralized call center in Peru, Illinois; and centralized the majority of our domestic inventory rebuying function. These activities also contributed to the increase in selling and warehouse operating expenses in 1996. Corporate general and administrative expense declined to 1.7% of net sales in 1996 from 1.9% in 1995, because we were able to spread the cost of centralized functions over our higher revenues. Goodwill amortization was 0.3% of net sales in 1996, compared with 0.2% in 1995. The increase in goodwill amortization between 1995 and 1996 resulted from our acquisition activity in 1995 and 1996.

As a result of the factors discussed above, income from operations was $101 million in 1996, a 46% increase over $69 million in 1995. Our operating margin decreased to 5.1% from 5.3% of net sales.

Interest expense was $8 million in 1996, compared with $1 million in 1995. The increase in interest expense resulted from debt incurred in conjunction with our acquisition and capital spending programs.

Income tax expense was $38 million in 1996, compared with $28 million in 1995. The increase resulted from our higher taxable income in 1996. Our effective tax rate also increased to 41% in 1996, from 39.5% in 1995, primarily as a result of increased nondeductible goodwill and foreign income taxed at a higher rate.

Net income increased 28% to $55 million, or 2.8% of net sales, compared with $43 million, or 3.3% of net sales, in 1995.

Public Offering
On April 13, 1995, we completed the sale of 10,637,500 shares of common stock, at a price of $12.50 per share, in an initial public offering. After the offering, Boise Cascade Corporation owned 82.7% of our outstanding common stock. Net proceeds were approximately $123 million, $102 million of which we used to pay a dividend to Boise Cascade Corporation and to replace working capital retained by Boise Cascade Corporation. The remainder of the proceeds-approximately $21 million-was retained by the Company for general corporate purposes.

In May 1996, we effected a two-for-one stock split of our common stock in the form of a 100% stock dividend. Each shareholder of record at the close of business on May 6, 1996, received one additional share for each share held on that date. The new shares were distributed on May 20, 1996. All references in this financial review to share amounts, earnings per share, average shares outstanding, and common stock prices have been adjusted to reflect the stock split.
On June 17, 1996, we filed a registration statement with the Securities and Exchange Commission for 4.4 million shares of common stock to be offered by the Company from time to time in connection with future acquisitions. At December 31, 1997, 3.5 million shares remained unissued under this registration statement.
On September 25, 1997, we issued 2.25 million shares of common stock at $21.55 per share to Boise Cascade Corporation for total proceeds of $48 million. At December 31, 1997, Boise Cascade Corporation owned 81.4% of our outstanding common stock.

Acquisitions
Through February 1998, our direct marketing subsidiary, The Reliable Corporation, acquired Fidelity Direct, a direct marketer of packing, shipping, and graphic arts products in Minnesota, and Sistemas Kalamazoo, a direct marketer of office supplies in Spain. The annualized sales of these acquisitions were $14 million at the time of announcement.

In 1997, we acquired eight businesses and entered into a joint venture, including two companies in France and one in the United Kingdom, for cash of $254 million, acquisition liabilities of $13 million, debt assumed of $10 million, and issuance of our stock valued at $3 million at the time of issuance. The annualized sales of the acquisitions completed in 1997 were $340 million at the time of announcement.

In 1996, we acquired 19 businesses, including four companies in Canada and three in Australia, for cash of $180 million, acquisition liabilities of $35 million, and issuance of our stock valued at $7 million at the time of issuance. The annualized sales of the acquisitions completed in 1996 were $460 million at the time of announcement.

In 1995, we acquired 10 office products businesses, including one in the United Kingdom, for cash of $62 million, payables to the sellers of $11 million, and issuance of our stock and a stock note valued at $18 million at the time of issuance. The annualized sales of the acquisitions completed in 1995 were $235 million at the time of announcement.

Goodwill, net of amortization, was $439 million at December 31, 1997, and $262 million at December 31, 1996. The increase was the result of acquisitions. We used purchase accounting to record our acquisitions. For more information on our acquisitions, see Note 9 in our Notes to Financial Statements.

Liquidity and Capital Resources
Our principal requirements for cash have been to make acquisitions, fund technology development and working capital needs, upgrade and expand facilities at existing locations, and open new distribution centers. The funding of our strategy for growth, including acquisitions and the relocation of several existing distribution centers into new and larger facilities, is expected to require capital outlays over the next several years. We expect total capital expenditures in 1998 of about $100 million, exclusive of amounts attributable to acquisitions. In 1997, such capital expenditures were approximately $67 million.

To finance our capital requirements, we expect to rely upon funds from a combination of sources. In addition to cash flow from operations, we have a $450 million revolving credit agreement that expires in 2001 and provides for variable rates of interest based on customary indices. The revolving credit agreement is available for acquisitions and general corporate purposes. It contains financial and other covenants, including a negative pledge and covenants specifying a minimum fixed charge coverage ratio and a maximum leverage ratio. Amounts outstanding under this agreement totaled $340 million at December 31, 1997. We may, subject to the covenants contained in the revolving credit agreement and to market conditions, refinance existing debt or raise additional funds through the agreement and through other external debt or equity financings in the future.

In addition to the amount outstanding under the revolving credit agreement, we had short-term notes payable of $23 million at December 31, 1997. The maximum amount of short-term notes payable outstanding during the year ended December 31, 1997, was $95 million. The average amount of short-term notes payable during the 12 months ended December 31, 1997, was $42 million. The weighted average interest rate for these borrowings was 5.8%.

Financial Condition
Cash provided by operations in 1997 was $120 million. This was the result of $98 million of net income, depreciation and amortization, and other noncash items, and a $22 million net decrease in working capital. Net cash used for investment was $350 million, which included $67 million for capital expenditures and $254 million for acquisitions. Net cash provided by financing was $246 million, which included $212 million borrowed under the revolving credit agreement and $48 million of proceeds from the issuance of our common stock, offset by the payment of $13 million of short-term borrowings.

Cash provided by operations in 1996 was $60 million. This was the result of $81 million of net income, depreciation and amortization, and other noncash items, offset by a $21 million net increase in working capital. Net cash used for investment was $239 million, which included $43 million for capital expenditures and $180 million for acquisitions. Net cash provided by financing was $177 million, which included $140 million borrowed under the revolving credit agreement and $37 million borrowed through short-term borrowing lines.

Cash provided by operations in 1995 was $50 million. This was the result of $57 million of net income, depreciation and amortization, and other noncash items, offset by a $7 million net increase in working capital. Net cash used for investment was $80 million, which included $22 million for capital expenditures and $62 million for acquisitions. Net cash provided by financing was $44 million, which included $123 million from our sale of stock, offset in part by a $78 million net equity transaction with Boise Cascade Corporation.

Disclosures of certain financial market risks
Changes in interest rates and currency rates expose us to financial market risks. To date, these risks have not been significant and are not expected to be so in the near term. Changes in our debt and our continued international expansion could increase these risks. To manage volatility relating to these risks, we may enter into various derivative transactions such as interest rate swaps, rate hedge agreements, and forward exchange contracts. We do not use derivative financial instruments for trading purposes.

In December 1997, we entered into agreements to hedge against a rise in Treasury rates. We entered into the transactions in anticipation of our issuance of debt securities in the first half of 1998. The hedge agreements have a notional amount of $70 million and will be settled in late March 1998. If the settlement rate, based on the yield on 10-year U.S. Treasury bonds, is greater than the agreed upon initial rate, we will receive a cash payment. If the difference is less, we will make a cash payment. The amount paid or received will be recognized as an adjustment to interest expense over the life of the debt securities to be issued. The settlement amount of $0.3 million as of December 31, 1997, was recorded as a deferred loss.

Approximately 20% of our 1997 revenues were generated from operations outside the United States. Our operations in Australia, Canada, France, Germany, Spain, and the United Kingdom, are denominated in currencies other than U.S. dollars. Each of our operations conducts substantially all of its business in its local currency with minimal cross-border product movement. As a result, these operations are not subject to material operational risks associated with fluctuations in exchange rates. Furthermore, our results of operations were not materially impacted by the translation of our other operations' currencies into U.S. dollars. Because we intend to expand the size and scope of our international operations, this exposure to fluctuations in exchange rates may increase. Accordingly, no assurance can be given that our future results of operations will not be adversely affected by fluctuations in foreign currency exchange rates. Although we currently are not engaged in any foreign currency hedging activities, we may consider doing so in the future. Such future hedges would be intended to minimize the effects of foreign exchange rate fluctuations on our investment and would not be done for speculative purposes.

New Accounting Standards
In 1997, the Financial Accounting Standards Board issued SFAS No. 130, "Reporting Comprehensive Income." This Statement establishes standards for reporting and display of comprehensive income and its components in a full set of financial statements. We will adopt this Statement in the first quarter of 1998. Also issued was SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information." This Statement establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. We are still evaluating what impact, if any, this Statement will have on us. We will adopt this Statement at year-end 1998. Adoption of these Statements will have no impact on net income.

Year 2000 Issue
Many computer systems in use today were designed and developed using two digits, rather than four, to specify the year. As a result, such systems may recognize a date of "00" as the year 1900 instead of the year 2000. This could cause many computer applications to fail completely or to create erroneous results unless corrective measures are taken. We utilize software and related computer technologies that will be affected by this issue. We are currently implementing, or have plans to implement, several computer system replacements or upgrades to allow our systems to properly recognize dates after December 31, 1999. We have reviewed what actions will be necessary to make our remaining computer systems year 2000 compliant. The expense associated with these actions is not expected to be material to the Company. We have discussed this issue with our significant suppliers and large customers to determine the extent to which we could be affected if their systems are not year 2000 compliant. While there can be no guarantee that systems of other companies will be corrected on a timely basis, we do not expect any material adverse effects to the Company.

Impact of Inflation, Seasonality, and Business Cycles
Management believes inflation has not had a material effect on our financial condition or results of operations. However, there can be no assurance that our business will not be affected by inflation in the future.

Although particular items we sell are seasonal (e.g., calendars and specialty gift items), our sales overall are not subject to significant seasonal variations.

A significant portion of our sales mix is represented by office papers. In early 1995, our gross margin was adversely affected by our inability to immediately adjust prices to our customers to reflect rapid increases in the cost of paper during that time period. We subsequently revised our contracts with customers to improve our ability to pass on cost increases. In 1996, paper prices were lower than in 1995, negatively impacting our revenue growth and operating expense leverage. In 1997, paper prices were more stable but lower than in 1996, constraining our revenue growth. Looking to the future, it is uncertain to what extent or when paper prices might significantly rise or fall and what favorable or adverse impact those changes might have on our sales and margins.

Our multifaceted growth strategy, including our acquisition program, was successful during 1997. We believe that this growth strategy will continue to be successful, but the year-to-year results of this strategy will depend in part on market conditions outside our control. In addition, the pace of our acquisition program will reflect the extent of opportunities available to us.

Changes in Management
On February 10, 1998, we announced that Peter G. Danis Jr., President and Chief Executive Officer, will retire following our annual meeting on April 21, 1998. Mr. Danis will continue to serve on our Board of Directors. It was also announced that Christopher C. Milliken, Senior Vice President, Operations, was elected to succeed Mr. Danis as President, effective immediately, and as Chief Executive Officer on April 21, 1998. Mr. Milliken was also elected as a director.

We also announced that Carol B. Moerdyk, previously Senior Vice President, Chief Financial Officer, and Treasurer, will become Senior Vice President, U.S. Contract Operations. Also, A. James Balkins III, Corporate Secretary, was elected Senior Vice President, Chief Financial Officer, and Treasurer. In addition, Richard L. Black, Senior Vice President, The Reliable Corporation, will assume responsibility for our European and Canadian operations.

Forward Looking Statements
This annual report includes "forward looking statements" which involve uncertainties and risks. There can be no assurance that actual results will not differ from our expectations. Factors which could cause materially different results include, among others, the success of new initiatives; the pace of acquisitions, same-location sales, and cost structure improvements; the changing mix of products sold to our customers; competitive and general economic conditions; and the other risks set forth in our filings with the Securities and Exchange Commission.

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