Borders Group BGP
January 16, 2003 - 9:36am EST by
elan19
2003 2004
Price: 15.90 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,272 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Borders Group (BGP) is a simple GARP investment: low valuation, strong balance sheet, transparent financial statements, conservative financial management, modest sales growth, a history of steady, double digit annual EPS growth, and relatively stable sales in the face of the recent pullback in consumer spending and intense competition. Like many retailers, BGP is having its worst year of SSS comps ever (-1% for Superstores compared to +2.0% and +2.3% for the prior two years) and has seen its stock price plummet much faster than its actual business results and prospects. Given that BGP currently trades at 9x sustainable free cash flow (very close to its historical low) and requires maintenance capital expenditures well below D&A, BGP is priced to earn a 15%+ annualized return if held long-term. However, I believe any sign of reviving sales growth will cause the stock price to be revalued to at least 50% higher than today’s price in the short-term. And there are three potential catalysts over the next year: the next Harry Potter book, easy sales comparisons in the second half of the year, and an expiring moratorium on state taxes of internet sales in November of this year (with states VERY eager to find new revenue sources).

What alerted me to consider investing in BGP is that, for the first time in over 3 years, BGP’s SSS comparisons at the superstores will be exceeding those of BKS for the current quarter. This alleviated some previous concerns I had regarding BGP’s category management initiative, declining sales at mall-based stores, and declining music sales.

While the return potential is not as high as many of the ideas posted on VIC, this stock is liquid and I believe the risk of permanent capital loss on BGP is low, for reasons I will discuss below. And for those who do not invest in the BKS stub because of inability to short out the GME subsidiary, BGP represents a more expensive, though still reasonably priced alternative. I’ve already done a writeup on BKS for VIC, so if you’re interested in this idea you can learn more by reading the BKS idea and all the followup posts.


SOME NUMBERS, IN MILLIONS (2001 means FY02 ending 1/27/02):

2001A 2002E
Sales 3388 3485
Net Income 87.4 109
D&A 96.2 97

Cash Flow* 212.6 220
Total CapEx 90.7 120
Maint CapEx ** 59 62
Sustainable FCF 153.6 158

Undiluted Shares 80.6 80
Mkt Cap 1272
EV 1422
EV/FCF 9.0

Estimated 2002 SSS Borders: -1.0%
Estimated 2002 SSS Waldenbooks: -2.8%

Projected 5-year store growth rate: 5%
Projected 5-year SSS growth rate: 2%
Projected 5-year total sales growth rate: 7%
Projected 5-year total earnings growth rate: 12%
(Note: These growth rates are more conservative than company’s stated goal of 8%-10% annual sales growth and 13%-15% earnings growth for the next few years)

* Cash Flow from operations EXCLUDES working capital changes, which I believe are irrelevant for BGP in determining sustainable free cash flow. Book retailers have the option to return books which don’t sell back to publishers, which means there is virtually no risk of markdowns or inventory writedowns. The markdowns you do see in bookstores are at the expense of publishers, not bookstores. I have no doubt that inventory will rise substantially faster than sales when Q4 is reported, due to the worse-than-expected holiday season. But I do not see this as reason for concern, as the inventory will be gradually reduced over the next couple quarters due to regular sales or returns to publishers. Note also that they have been making ongoing improvements to their inventory control systems and have been seeing inventories reduced as a benefit from their category management initiative, which in the end will matter more than a quarter or two of soft sales.

** Much of maintenance CapEx is actually spent on one-time costs such as systems improvements and in-store web technologies as opposed to the physical stores, so the maint CapEx numbers I used could be considered conservative. However, if music trends continue to deteriorate, I think CapEx spent on store resets are likely to occur over the next few years. Balancing these two factors, I think my Maint CapEx numbers are a decent compromise.



WHY THE STOCK PRICE IS DEPRESSED:

1) Negative sales trends during the past half year due to depressed consumer spending, which also resulted in a mild earnings warning for Q4.
2) The perception that AMZN will rapidly grow book sales at the expense of book retailers such as BGP, and/or lead to profit-destroying price discounting among bookstores.

Consumer spending is unlikely to remain depressed forever. If you think it will, then obviously you shouldn’t invest in any retailer of discretionary items, and should stop reading this writeup. When consumer spending resumes its normal pace of growth, BGP’s comps are likely to return to positive low single digits, slightly higher than the pace of growth experienced by the book industry as a whole.

While I have no idea when consumer spending will resume its normal growth rate, there are a few catalysts likely to affect all booksellers during the next year:

1) The next Harry Potter book will be published on June 21. This will lift sales by at least 2% for Q2, if history is any guide.

2) Sales comparisons for every quarter in 2003 will be easy, but especially Q4.

3) The moratorium on the internet sales tax will be expiring in November of 2003. With most states facing large budget deficits, I doubt that the moratorium will be extended (though Sen. Ron Wyden (D., Ore.) and Rep. Chris Cox (R., Calif.) introduced a bill earlier this month that would indefinitely extend the moratorium that was set in a 2001 bill). Many states are looking for new revenue sources and are considering implementing a sales tax on retail items sold through the internet (i.e. California). If this occurs, it will level the playing field for all booksellers. Much of the price advantage for buying new books from AMZN as opposed to BGP or BKS is currently due to lack of sales tax for AMZN retail sales. (Note, though, that buying used books on AMZN will still be considerably cheaper than buying new books from BGP, BKS or AMZN). Personally, I think this will have a minimal impact. But many investors have a perception that BGP and BKS are at risk from internet retailers who can sell for lower prices. This may be the catalyst that finally dispels that notion.

Indeed, the main objection most investors have to investing in BGP (or BKS) relates to the intense competition from AMZN and other book retailers. Intense competition among book retailers has existed since the superstore concept was launched over a decade ago, yet the superstore concept (on a SSS basis) has grown at least as fast and usually faster than the book industry over the past decade. These market share gains have come at the expense of mall-based stores and independent book retailers. AMZN simply accelerated this trend – more sales going to superstores and AMZN, less to everyone else.

However, a careful analysis of AMZN sales for the last 2 years shows that AMZN has essentially stopped growing its sales of new books over the internet in spite of recent price cuts, though rapid growth of used and surplus books through its marketplace program continues. It may be that the overall market for new books is shrinking a little due to the greater ease of buying used books. But even if the overall size of the new book market is shrinking, BGP and BKS continue to gain market share, and both are large enough to benefit from purchasing and distribution advantages over their smaller competitors.

The simple fact is that AMZN was handed several billion dollars of low cost capital to go grab market share in books, yet this has hardly put a dent in either BGP’s or BKS’ growth relative to the (new) book industry as a whole, while BGP’s gross margins have held steady for the last 2 years. This is a forceful demonstration of the viability and resilience of the superstore concept in the face of new competition on a scale rarely experienced among retailers. And I think it’s pretty unlikely we’ll see another few billion dollars thrown at this industry by the capital markets any time soon. For further detail on AMZN sales data, see my analysis on messages 24 and 25 of the BKS idea.

One positive about Border’s that is often overlooked is that their sales per square foot, sales per store, and other similar metrics are the best in the industry for both the superstores and mall-based stores (though BKS is very close on the superstores).

MORE DETAILS (FOR THOSE WHO ENJOY READING LONG WRITEUPS)

BGP has about 13% market share for new book sales in the U.S. I estimate sales at Borders to be broken down as follows for 2002 (millions):

Borders (U.S.) 2,326 67%
Waldenbooks 843 24%
International 316 9%

The growth is coming from Borders (U.S.) superstores and International superstores. The mall-based stores of the Waldenbooks division is actually shrinking, as management is selectively not renewing leases on stores whose performance is too poor. SSS sales trends at Waldenbooks have been deteriorating for several years due to declining mall traffic and the growth of superstores and AMZN. Last year the comps were –3.7%, and this year I believe they will be around –2.8%. These stores still represent over 20% of Border’s overall sales and an even higher portion of profits. So this is certainly a negative. But management has been doing a great job of harvesting profits from these stores while keeping capital investment to a minimum. Also, it doesn’t hurt that competitor BKS has much more rapidly closed their mall-based stores; it means the remaining BGP stores are less and less frequently facing competition from a second bookstore in the same mall, and probably gets more management attention then the Dalton stores owned by BKS. Lastly, I think it’s important to note that Dalton sales are declining at approximately the same rate as mall traffic is declining. When mall traffic starts to increase again, I think it’s reasonable to expect that sales will increase at Dalton stores, as they are now the only bookstore in many malls.

While recent sales trends at the mall-based stores are hurting BGP’s results, the Border’s stores have a much greater impact. Both BGP and BKS believe there is much room for expansion of the superstore concept in the U.S. The combination of BKS, BGP, and BAMM superstores represents about 25% market share for U.S. book sales, so further market share growth is possible. And the unit economics on these stores are good. Border’s management claims that the average store breaks even at the end of the first year and generates a 30% return on capital at the end of 5 years. Also, the stores do not require any additional capital expenditures for at least 5 years, when the stores finally begin to need repainting and new carpets. As a result, D&A will consistently exceed maintenance capital expenses for many years to come, as a large portion of Border’s stores are less than 5 years old. This of course also means that earnings will grow faster than sales as the stores mature. It also means ROIC and ROE will be gradually improving over the next few years from current mediocre levels (partly due to the maturing stores, partly due to increasing inventory turns from their inventory systems improvements).

BGP is also enjoying success with their stores in England and Australia. While currently less than 10% of overall sales, BGP expects to open 8 to 10 stores per year overseas over the next few years. 4 of their 10 highest sales volume stores are international stores. When domestic growth opportunities slow down a few years from now, they will be able to continue expanding internationally.


A few points about the Border’s superstores are worth noting:

Superstore bookstores like Borders and Barnes and Noble are more than just a store. They are a community gathering place where author readings happen, people read at the in-store café, and people spend a long time browsing the shelves; the average Border’s customer spends 54 minutes per store visit. Border’s also hosts live music in their stores. This community gathering place concept means that these stores are not selling a pure commodity (books and CDs) but also a service (community gathering spot) which is less easy to duplicate. That is largely why I believe the AMZN threat to bookstores is overblown. It is also why I believe the risk of permanent capital loss is low for an investment in BGP –community gathering places foster loyalty that cannot be matched by a small mall-based store or an internet bookseller. Some independent bookstores also do a good job at this, but their smaller scale and resulting higher cost structure does not allow them to sell books as inexpensively as BGP or BKS.

Music sales represents nearly 20% of Border’s sales (as opposed to 5% at Barnes and Nobles). The music industry has seen sales dropping at a rate of nearly 10%/year for the last 2 years, partly due to less exciting releases, but mostly due to illegal copying over the internet. This is most of the reason that Border’s SSS have lagged BKS’ SSS for the last 3 years; BKS music sales are restricted to Jazz, Classical, and Blues, which apparently customers are more willing to pay for as BKS music sales are growing. While this is a big short-term negative, I believe that management is rational and will take appropriate action if this trend continues. This could mean yanking music out of the stores altogether (like BAMM), or reducing the music section to an offering more similar to BKS. In either case, I am expecting significant CapEx over the next few years for store resets if these trends continue.

Over the past year, CEO Josefowicz (whose background is with food retailer Jewel-Osco) has been applying the grocery practice of category management to Border’s. It has been enhancing profitability and efficiency (and reducing inventory), but it is unclear whether it has been having an impact on sales. Until now, I steered away from BGP specifically because I feared that category management would result in fewer titles and therefore shoppers going to BKS instead of BGP. This does not appear to be happening. In fact, BGP’s SSS for the holiday selling season in 2002 came out slightly better than BKS, for the first time in years (though both were negative).

BGP’s promotional strategy is very different than BKS, and has so far resulted in higher profitability. BKS relies on a “Reader’s Advantage” loyalty program which gives customers a 10% discount off all titles for a $25 annual fee. Border’s has tested such a program but indicated they will probably not roll it out nationally for the superstores (thought it has had such a program in place for its Dalton stores for a decade). Instead, they have been offering sales on specific titles and emphasized print advertising. The result has been a higher level of profitability than BKS (when comparing superstores to superstores).

BGP and BKS bookstores have other significant differences in addition to those described above. The key concept describing their difference is that they are going for a slightly different demographic. BKS with its more expensive store furnishings and “sophisticated” music offerings is going after the highly educated and perhaps higher income consumer. BGP’s store format targets more mainstream, popular culture, with its more diverse music offerings and live musical entertainment. I think both formats work, though I have noticed anecdotally than consumers often have a decided preference for one or the other (or neither, for those who automatically avoid all chain stores).

BGP management is delightfully candid in their shareholder reports and their conference calls. BGP management has always been financially conservative, keeping debt to a minimum and finding ever more ways to lower expenses. They have a strong aversion to money losing projects, which is why they aborted the money losing internet operations and pursued an AMZN-based internet sales strategy instead (which may yet lead to benefits such as in-store pickups from customers who order from AMZN).

They have engaged in modest stock buybacks, subject to restrictions from some of their lease facilities. On the last CC, they indicated that they are considering instituting a dividend. And I like their use of a management stock purchase plan for executives, as opposed to the standard practice of relying entirely on options and bonuses. All signs indicate that this is a management that will not pursue growth at any cost, but will pursue owner-friendly financial policies. A danger to watch out for here is that they may be too conservative, allowing more aggressive competitors to leapfrog ahead of them in terms of giving consumers what they want.

WHAT TO BE CONCERNED ABOUT (mostly a recap of items already discussed)

Mall-based stores (>20% of sales) are losing share to superstores and internet sales.

Music sales at the superstores (20% of superstore sales) are dropping at a rate of almost 10%/year, mostly due to illegal music copying on the internet.

Category management, if taken too far, may drive away customers who want more variety.

15.4 million options are outstanding (though nearly half are out-of-the-money), and options grants relative to shares are around 5%/year. This is mostly offset by forfeitures. Options issued net of forfeitures is averaging less than 1% per year. I asked I.R. about this and found out that the forfeitures are due to the fact that options are very broadly issued, and this includes all full-time store level employees. So the high level of forfeitures is due to high turnover at the store level. While turnover in retail is normal, I have to wonder if the use of options is having much of an impact in slowing the turnover rate. They are considering changes to the stock option plan but did not provide details.

In the end, the main concern with retailers is always sales. No matter how irrationally priced, worsening near-term sales trends correlate strongly with declining near-term stock prices. I see the biggest risk being that sales will worsen in the near term due to even weaker consumer spending, no matter how many positive factors are at work.

Catalyst

1) The next Harry Potter book will be published on June 21, which should lift sales by at least 2% for Q2.

2) Sales comparisons for every quarter in 2003 will be easy, but especially Q4.

3) The moratorium on the internet sales tax will be expiring in November of 2003, with cash strapped states are looking for extra revenue sources.
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