Description

Borders (BGP), the book superstore is a balance sheet improvement plus margin expansion story that should play out in the next two years. During this time, management will generate significant cash from improving working capital, divesting the international business and closing money losing Waldenbooks locations.  Additionally, through several initiatives management will improve domestic superstore margins.

The stock has dropped a fair amount since June as turnaround stories fell out of favor.  As a result, under very reasonable scenarios there should be 70%+ upside from current levels and little downside.  Using even more conservative assumptions than management’s recently announced strategic plan will result in the company trading at 3.5x EBITDA and single digit P/Es in a couple of years.

Management expects about $235MM of cash will be generated by improving inventory turns and liquidating underperforming Waldenbooks stores by the end of 2009.  Additionally, management believes that there ultimately could be significant upside from even further working capital progress.  BGP’s current systems are clearly dated and inefficient.  For example, buyers have no open to buy and can only screen stores 25 at a time – it’s a manual process vs. Barnes and Nobles’ automatic replenishment.  This is basic blocking and tackling.  Management appears to be making progress on its inventory in the latest two quarters and in our recent conversations seems to be more focused/confident than ever on turning its inventory into cash over the next couple of years.  A new CIO was hired in August.  It should be noted, that Borders is not trying to “reinvent the wheel,” but rather just to employ the same type of systems that have long been successfully used by Barnes and Noble.  For conservatism’s sake, our model is run at $185MM of cash generated from working capital initiatives and Waldenbooks.  Beyond the Borders’ working capital initiatives, the company should roughly generate an incremental $100MM in cash from the divestiture of its international unit.

Turning to margins… Domestic superstore EBITDA margins were close to 10% a couple of years ago; now they are in the depressed zone of 6.0%.  By way of comparison, Barnes and Noble is currently running at about 8.0%, and expecting to grow margins over time.  Borders’ goal is to return domestic superstore margins to 9% by 2009.  For conservatism’s sake, our model is run at 8.0%.  The margin improvements should come largely from some mix shift initiatives.  First, the company is expanding the amount of real estate it devotes in each store to Paperchase, a division of Borders that sells stationary, cards and gifts.  Paperchase has high single digit comps and the best margins in the store.  Borders’ Cafés are another growing piece of the company with high margins.  Helping matters even more, the real estate being turned over to Paperchase and Borders’ Cafés is coming from the struggling music department.  Also enhancing margins, the company is planning on doing more self-publishing (could mean as much as 50 bps) and stocking more bargain books.  These initiatives are all underway.  There is also some level of excess costs (internet site development spending with no earnings offset, which will change in Q1 of next year) and higher than targeted shrinkage/café waste levels that are flowing through the margin line as well. 

Borders also has a formidable asset in its rewards program where it has 5x (22MM) the number of members as Barnes and Noble.  On average, Borders gains 140,000 new members a week.  Borders’ program is free to join while Barnes and Nobles charges $25 annually.  Management is considering charging a fee for its reward membership program.  We are not modeling any revenues from such a fee, but we do think it is reasonable to believe rewards members will pay something for a Borders membership.  If Borders successfully charged half of those members an annual fee of $2.50/year, EBITDA would increase $27.5MM (which would take margins up 90 bps).  Most importantly, the rewards program is helping generate traffic and loyalty (traffic has increased in 22 out of the last 23 weeks).

There is a significant international franchising opportunity for Borders and management is ramping up this effort.  A hypothetical example of the impact – 50 franchised stores at $5.8MM each of annual sales and a 4% royalty rate could mean $11.6MM of income (this would take the margins up 40 bps).  This opportunity is not in our numbers. 

Management has recently stated that Borders is on or ahead of plan with its balance sheet and margin initiatives, and the CEO recently bought a decent amount of shares.  Furthermore, on the latest conference call he said he plans to buy even more stock.  When all is said and done, we think the company should trade for at least 5.5x-6.0x EBITDA, and a reasonable case can be made for a higher multiple.  At 5.5x 2009 EBITDA, you would have a $20 stock or 83%+ upside including dividends (there is currently a ~ 3.8% dividend yield) using our 8.0% domestic superstore EBITDA margin. 

There are other ways to win.  If the private equity market ever restarts, Borders is a solid LBO candidate at much higher prices.  Financing high quality inventory that can be put back to publishers is obviously more doable than leveraging other retail situations.  Since a lot of the value creation is executing on the inventory front, this is something that a private equity firm should feel more comfortable hanging an investment thesis on vs. hoping for higher multiples and dividend recaps.  Also, Borders has strategic value for Barnes and Noble (which could unlock a great deal of the purchase price very quickly by reducing the working capital).  The Whole Foods saga ended favorably and there have been rumors in the past about Barnes and Noble being interested in Borders.  Finally, Paperchase could be spun-off at a decent price. 

Catalyst