When Office Depot wanted to start over again, it didn't go back to the old drawing board. Instead, it turned to the old furniture store. An abandoned furniture store slated for demolition that is — with brown paper over the windows. It was there that the office supplies chain launched a secret project to completely overhaul its store design.

Office Depot is plagued by a problem that can be deadly in the retail business: lack of differentiation. According to Office Depot's market research, roughly 50 percent of its customers don't know if they bought those post-it notes or glues sticks from one of their stores or from competitors Staples or Office Max.

“There is not a discernable difference (between the stores) in many customer's minds,” says Wendy Liebmann, president of WSL Strategic Retail in New York. “Good retailers find a way to set themselves apart from their competition.”

Office Depot suffered from more than just lack of differentiation. Operating profits in 2003 for North America slipped 25 percent, or more than $100 million. And only after four years of declining comp-store sales did the chain see a 4 percent gain in the first quarter of 2004

Part of the problem is that Office Depot is squeezed between market-dominator Staples and large retailers like Wal-Mart and Sam's Club. “The marketplace is kind of split between those two and the challenge has been how do you beat the specialty competitors and the box price competitors,” says Liebmann.

Late last year, Office Depot CEO Bruce Nelson decided to remedy this problem with a massive store redesign project. The idea was to create a store less expensive to open, more efficient to operate and more convenient to shop. With the secrecy of a UFO investigation, Nelson rounded up a team of seven Office Depot employees, including high-level executives and newcomers, to brainstorm a different design.

In a company with more than 40,000 employees in North America alone, these eight were the only ones who knew about the project. “We wanted to work at a rapid pace,” says Joe Jeffries, director of store operations and a member of the clandestine design team. “We knew if we went public with what we were doing, the corporate machinery would slow down the process.”

The team spent time browsing at office store competitors and such big boxes as Target, Wal-Mart and Sam's Club to find what worked and what didn't. One new packaging idea gained from the experience was “display-ready” trays. The trays allow employees to just open a box and place items on the shelf, which reduces time spent restocking shelves.

Ideas were also borrowed from M2's predecessor; the Millenium store format, which was released in 2001. Like the new design, the Millenium format was also created to be an alternative to the large warehouse.

However, due to the high costs of its large size, the Millenium was discontinued after 27 stores were released in 2002.

The Millenium design didn't prove to be a total loss though. The design team took the idea of clear sight-lines and used it for the M2 prototype.

The team then retreated to the furniture store to create a visual prototype. To maintain secrecy, the abandoned site was chosen over the company's own test facility. Within nine days, the property was found and leased from the owner.

“As though it was a giant erector set, excess shelving of many different kinds were ordered as the team began to push the vision towards reality,” says Chad Mikula, director of North American retail and another member of the design team. Using all the items found in a typical store, the team went through several different prototypes before settling on a final design. Miller Zell, a design-consulting firm based out of Atlanta, was then hired to create new signage.

After months of secrecy, the new M2 design was ready for unveiling. A ribbon-cutting ceremony was held in June for Office Depot's new store in Venice, Fla,; the first store based on the new M2 design.

So what's different about the M2 design? First, the Millenium2 is smaller, taking up only 17,500 square feet instead of the usual 19,500 to 20,000 square feet. Reducing store size saves money by reducing the sales floor by 10 percent.

The design also makes it easier for the average customer to find what they need. According to Office Depot's research, 60 percent of customers walking through the front door have to ask where to find a product. A racetrack design with low center fixtures and clear sight lines makes product identification easier. Core supplies are placed around the store's perimeter, while furniture and technology are in the center. Store employees are also located here in the center so they can easily spot customers.

Other cost savings include a 40 percent reduction in IT infrastructure as well as a 15 percent savings through a significant reduction of in-rack lighting. Products are now grouped in visible, horseshoe-shaped pods, or “mini-worlds”, placed near related products for easier access. For example, toners are placed near paper products.

“The pod format makes it easier to see, because with (the traditional) aisles you can only see the four to eight feet in front of you,” says Mikula. “You can now turn your head from left to right and quickly see what products we have available.”

M2 is meant to be more pleasing to the eye with a color palette of orange, lime green, aqua and purple. The store also provides improved signage with way-finding graphics. For example, the section of the store that sells pens would be marked with a large poster of a marker. “It's designed to be not only eye-popping, but you can also see the graphic from any vantage point in the store,” says Mikula.

Office Depot plans to use the M2 format for all new stores. In March, Office Depot purchased 124 Kids “R” Us stores for $197 million. The company will turn 50-60 of these locations into new M-2 stores. Many of the new stores will be built in the Northeast, where the company hopes to take market share away from its deeply entrenched competitor Staples.

“We will leverage the M2 format along with our recent purchase of Kids “R” Us locations…to provide immediate access to large areas of the country in which we do not currently have a strong retail concentration, such as Massachusetts, New York, New Jersey and Pennsylvania,” says Nelson.

Staples has implied that that the M2 design imitates Staples' Dover store format. Unleashed in 2002, Staples now has about 400 stores in the Dover prototype. Both stores were designed to move away from the warehouse format and make it easier for customers to find items. Both stores have a racetrack design, improved signage and adjusted adjacency to make product identification easier.

However, officials at Office Depot maintain that their prototype format and signage is unique. “There's absolutely no comparison in the two formats,” says Mikula. “I believe if someone made that comparison, they haven't seen the two formats.”

In total, Office Depot plans to open 80 to 100 M2 stores this year. Plans for 2005 include more than 100 new stores in North America. The company also plans to remodel 40 to 50 of its current locations into the M2 format. Due to M2's smaller size, remodeling costs have dropped an average of $100,000 to $350,000 to $450,000 per store.

How successful Office Depot's new store design will be in penetrating the Northeast market and creating store identity remains to be seen. “Although we like the look of the new M2 store format and the cost-savings feature, we would like to remain on the sidelines until we get some supportive financial data that will be the ultimate test of the success of this new format,” says Michael Baker, an analyst for Deutsche Bank Securities.

Others, however, see a positive future impact on profits. Brit Beemer, chairman and founder of America's Research Group, said a unique format helped Circuit City stand out from the crowd. The chain's store design, with a three-story tower, a two-story front and one-story store, proved to be a formula for sucess. Time will only tell if the same holds true for Office Depot.

“If what they've created is a solid look, it should have a definite improvement in earnings,” said Mr. Beemer.

REFORMATTING

PROBLEM:

In the office supplies market, where products are commodity items, customers have a hard time distinguishing one chain from another. A recent study by Office Depot indicates half can't remember where they made their last purchase. How can one retailer differentiate its stores from another to attract loyal customers?

SOLUTION:

Office Depot reinvented the store format. It picked a secret location, which it turned into a lab for designing its new Millenium2 (M2) store model. The M2, created to have a warmer feel than the typical warehouse, is built around a racetrack design with products in easy-to-refill pods, reducing costs and making it easier to shop.

BUZZ:

Many of the new M2 stores, about 80 to 100 of which will be opened this year, will be located in the Northeast at sites Office Depot purchased earlier this year from Kids “R” Us. The chain hopes the new stores will usurp Staples' dominant position in the region.

DATA:

The new format takes up less space — about 17,500 square feet; compared with the usual 19,500 to 20,000 square feet. It also will cut lighting costs by about 15 percent through a reduction of in-rack lighting.

OFFICE DEPOT BY THE NUMBERS

2003 2004E
North American Same Store Sales Growth -4% 3%
Total Same-Store Sales -2% 2%
North American stores 900 980
International Stores 64 74
North American Square Feet 23.6 mil 25.8 mil
North American Sales Per Store $6.4 mil $6.4 mil
North American Sales Per Square Foot $241.34 $242.25
Source: Company reports, SG Cowen estimates