March 17, 2005
Editor: Ian Madsen, MBA, CFA
Tel: 1-800-767-3771, x 417
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Borders Group Inc. (BGP – NYSE) $25.77
Note to reader: This report contains substantially new material. Subsequent editions will have new or revised material highlighted.
Overview
Based in Ann Arbor, Michigan, Borders Group Inc. (BGP) operates 410 book superstores under the Borders name throughout the U.S. as well as another 33 international stores and 37 Books Etc. stores located in the United Kingdom (which together account for approximately 75% of the company's total sales). Borders’ freestanding superstores average 24,500 square feet in size and generate approximately $6.7 million in sales per store. The Borders stores carry an average of 140,000 books, 40,000 music titles and 7,000 video titles. In addition, Borders stores sell food and beverages through an in-store cafe. Borders also operates the mall based Waldenbooks chain, which includes 775 stores that average 3,500 square feet in size and generate sales per store of $1.1 million.
Borders is a leading brand name in a relatively stable sector, with little inventory risk. The company has taken important steps to improve its game through category management, new promotional spending, and ongoing cost controls. Analysts believe that the international segment's (14% of sales) store base should triple in the next three years in existing countries. The BGP superstore base is growing at 8.6% and is forecasted to be at 645 stores by 2008. Mallstores are declining at 5.3%, and overall square footage is growing 8.1% annually. Operating margin should be enhanced by maturation of international business; average age of stores at two years. Moreover, Waldenbooks' leases are being lowered on renewals. BGP has a very strong balance sheet.
Key Positive Arguments / Key Negative Arguments· The book industry allows for stable (but slow) growth that is resilient even in a weak economy.
· Borders create a pleasant atmosphere for customers with plenty of reading space, a wide selection of books and music titles, and coffee shops.
· Because book retailing isn't a high-growth industry, Borders continues to improve the efficiency of its operations in order to achieve its earnings growth targets. / · To operate its bookstores requires a great deal of slow-moving inventory, making it difficult to generate high returns on invested capital.
· While the company’s Waldenbooks franchise generates a decent amount of cash, it continues to pull down Borders’ overall sales and earnings growth.
· Management’s efforts to stimulate growth such as selling seasonal gift items, music, and DVDs may not go as planned, leading to inventory write-downs.
Borders’ fiscal year ends January; all calendar references are to the fiscal year.
Sales
Analysts (Barrington, Goldman, Jefferies and Merrill) expect Borders Group to increase its sales 10.4% in 2005.
Fourth quarter summary: Borders, posted fourth-quarter revenue of $1.37 billion, an increase of 4.3 percent over the same period a year ago. As previously announced, comp trends at the Borders superstores improved after the company’s holiday sales release in mid-January. With the exception of snowstorms during the last weekend of January, same-store sales growth through February 9th had continued within the company’s Q1 guidance for a low-single-digit increase. While management reiterated its Borders superstore comp guidance, one analyst (Jefferies) believes that increasingly difficult comparisons throughout the first quarter will make same-store sales growth challenging. Therefore, they anticipate Borders superstores same-store sales growth of flattish to slightly positive during the quarter
Older store sales comparisons do become easier during the second half and should get a significant boost from the July 16th release of the 6th Harry Potter book, “Harry Potter and the Half-Blood Prince.” Waldenbooks same-store sales growth guidance has been reduced for the full year. Previously management guided for flattish comps at Waldenbooks and now management anticipates a low-single-digit decline. This could partly be due to the increased store remodel and rebranding activity this year to the Borders Express format, which is likely to cause temporary traffic disruptions until a store is complete. Furthermore, management has decided not to close any Waldenbooks stores this year due to their contribution to cash flow, despite the likelihood that same-store sales growth is still underperforming at many of these stores. International sales growth continues to be strong, up 27.7% in the quarter (up 20.1% excluding foreign currency benefits). This division now represents 13.2% of total company sales versus 11.0% last year and the analysts feel that its contribution will continue to increase if management’s targeted sales growth of 20%-25% this year is achieved. Segment profits grew 48.5% to $14.4 million from $9.7 million last year, which resulted in this division turning profitable for the first time this year.
Analysts are of the opinion that including new stores, approximately 150 Seattle's Best Coffee cafes and 70 Paperchase locations will be installed in 2005. The transition of cafes to Seattle's Best Coffee leverages Seattle's Best brand versus what has previously been a "private-label" effort. The introduction of Paperchase to US stores presents potential for further rollout in the US, providing incremental sales. As part of the remodeling effort, they are seeing some improved book merchandising in the US focusing on higher-margin "mid-list" books, i.e. the tier of fiction below bestsellers, with better use of shelf space, call-out displays and face-outs. These efforts should combine to drive sales higher with favorable mix implications, where decline in music sales should be offset by higher café, gifts, stationery, and books sales. Analysts expect incremental sales coupled with improvement in sales mix and reduction in working capital to offset the increase in remodeling costs.
One analyst (Suntrust) reminds investors that BGP’s sales growth will be positively impacted by an extra week in 2005 (roughly 1.5%).
See the BGP consensus earnings model for more details on the analysts’ sales estimates.
Margins
The analysts (Barrington, Merrill, Goldman) forecast Borders’ profit margins to remain stable in 2005 and 2006.
Fourth quarter summary: Gross margins decreased nearly 40 basis points, excluding 10 bp of inventory write-downs, as fewer bestseller discounts were more than offset by the deleveraging of supply chain costs. Adjusting for recent changes in lease accounting, the SG&A expense ratio delevered by 100 bp due to increased promotional spending and rather weak domestic sales growth.
Operating profits in both of BGP’s core US business fell short of majority of the analysts’ forecast as the company digested negative expense leverage on modest same-store sales, and absorbed increases in freight costs as it worked to shave inventories with aggressive returns to vendors. International stood out as a bright spot, with net profit growth of 48%.
In February, BGP announced aggressive reinvestment in its business, including an acceleration of its remodeling program to 80-100 stores from 40 in 2004, the conversion of 130 cafes to the Seattle's Best brand, and some addition of products from the UK Paperchase acquisition to the US. These will be reflected in projected non-operating costs of $0.08-$0.10, up from $0.04-$0.05 in 2004, as the company funds the renovations and writes down existing assets.
See the BGP consensus earnings model for more details on the analysts’ profit margin estimates.
Earnings Per Share
The Digest Average for FY 05 is $1.71.
Borders Group reported fourth quarter earnings per share of $1.62 versus last year’s EPS of $1.49 and the consensus forecast for $1.61. Earnings per share came in at the high end of management’s guidance for $1.61-$1.62. It’s important to point out that EPS growth was primarily driven by share repurchases and improvement made at the International segment, as the domestic bookstore net income was essentially flat year-over-year. As expected, non-operating asset impairment write downs related to accelerated depreciation on store remodels and store closings negatively impacted the quarter by $0.05. Results also included a $0.01 charge for the correction of Border’s lease accounting to comply with a recent SEC clarification, which has affected most publicly traded retailers.
See the EPS and Recent Revisions tabs in the BGP consensus earnings model for more detail.
Target Price / Valuation
Majority of the analysts (88%) have a neutral rating while only one analyst (J.P. Morgan) has a negative rating on the shares.
Since most of the analysts have not come up with a target price, the digest average is not indicative of all the analysts’ opinion.
Go to the valuation tab of the BGP earnings model spreadsheet for more details on the brokers’ valuation methodologies and individual price targets.
Long-Term Growth
According to Veronis, Suhler and Associates, total U.S. consumer spending on books should increase at 2.8% per year and reach $20.5 billion in total sales in 2006. Given the industry’s meager growth, Borders’ will have a difficult time achieving sustainable revenue growth above 3% over the long-term.
In 2005, the company is accelerating the superstore remodeling process to be between 80 and 100 stores. By the year-end (given that new stores will also reflect the look), this would equate to some 35% of the store base reflecting the new look. Although the sales lift has not produced the expected 5% bogey, better gross margin rates (due to mix shift) and some restrained investment are enabling the company to realize its ROIC goal. Moreover, the remodeled stores, going forward, will feature a Seattle’s Best café and a full Paperchase department, both of which should enhance the sales lift at future remodels.
BGP is planning to convert 40 Waldenbooks stores to the Borders Express format in 2005.
One analyst (SunTrust) contends that the turnaround in the international business (meeting sales and profit goals) continues to be a positive and is an increasingly important source of long-term EPS growth.
Interestingly, the Research Digest average of Borders’ long-term earnings growth rate is 12.8%, which seems pretty generous given the analysts’ generally lukewarm view of the book industry’s fundamentals.
Individual Analyst Opinions
POSITIVE RATINGS
None
NEUTRAL RATINGS
Goldman – In-Line: report date 03/11/05
The analyst views BGP as an attractive value story, generating improved sales performance and maintaining operating margin while absorbing accelerated investment in its store base and the expensing of options. 4Q04 results were middling in the context of this outlook, with improvement in sales momentum, but a lack of operating leverage at the core BGP business. However, with its solid capital allocation discipline through share buybacks, dividends payout, and increased reinvestment in existing stores, they expect BGP to bridge this valuation gap.
Jefferies – Hold ($24-$26.50): report date 03/11/05
“We are maintaining our Hold rating and are adjusting our 12-month targeted price range to $24-$26.50 from $22-$25 previously.”
Merrill – Neutral: report date 03/11/05
“We like the Borders focus on capital discipline but have a hard time getting interested in the stock at current levels. Borders trades close to the high end of its five-year historical P/E range in spite of prospects for slower growth. Plus, in our view with cost savings having run their course, we think the company is becoming more dependent on top-line where its track record is not as strong. We rate Borders Group Neutral.”
SunTrust Robinson – Neutral: report date 03/11/05
The analyst is of the opinion that the stock is at 14x expected calendar 2005 earnings versus an expected growth rate of 10% to 15%. At this juncture, given the problems in the sector (saturation, sluggish backlist demand, declines in music sales, creeping digitalization), they feel that it is difficult to see a sustained upward move in valuation. Consequently, they retain their Neutral rating but recognize that the shares are appropriate for balance sheet-focused investors.
NEGATIVE RATINGS
None
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