Borders Group - BGP
Note: this is a corrected version of the post made a few hours ago, now removed.
This is an analysis of Borders Group done for my investment club. Comments appreciated.
History
Purchased 200 shares 3/3/99 at 13.34, basis $2,668.75
Latest price 5/11/01 $19.17
If sold, less commission, would net $3,804.10, for annualized return of approx 17.8%
BGP has met (and slightly exceeded) our minimum expectations of 15% annualized growth.
Basis for purchase was steadily increasing sales on a very constant annual increase of about 13%, since 1992. Earnings had been erratic, with losses in 1993 and 1995, but for 1996, 1997, and 1998 earnings had been strong and growing, though the curve was flattening.
The stock price had dropped from a high of 41, in what we felt was an overreaction to a modest 4th quarter 1998.
We therefore bought at $13.34. The minimum goal, therefore, became a stock price of $27 by 3/04. We had a bounce shortly after purchase, which seemed to validate our analysis, but then the stock dropped again, to as low as 10.9. It has recently nearly doubled, to 19.17, near the 52 week high of 19.98 but nowhere near recovering its 1998 high of 41. However, the stock is on track to meet our five year goal if it continues its present growth trend.
Analysis of the 2000 Annual Report and 10-K, however, shows some concern whether the stock can continue its pattern of growth.
EPS for the past for years were: (FY 1996 ends late Jan 1997, etc. This is how BGP states their FYs, though others, such as Quicken and First Call, consider the year ending Jan 2001 to be FY 2001. Love these different denominations – make comparisons really fun!)
FY 1996, .70
FY 1997, .98 (+40%)
FY 1998, 1.12 (+14,29%) (our buying point)
FY 1999, $ 1.13 (+.9%)
Earnings for FY 2000 are reported three ways. Reported earnings were $.54, or down 52%. However, BGP took a big one-time write-off of All Wound Up, a disasterous acquisition/attempt at diversification. (I am happy to say that this sort of diversification does not appear in their future plans.) Diluted EPS from continuing operations were $ .92 (-18.6%)
Diluted earnings from operations "Before asset impairments and Other Writedowns) were $1.21 per share (+7.08%). This is probably the correct number to use for future growth projections. (AAII uses .68; First Call uses $1.15, S&P uses $.67. I have no idea where these other figures come from. Quicken doesn't even have FY 2000 data yet.)
BGP is divided into four basic divisions. With dollars in millions:
Borders Superstores – 2000 sales $ 2,090.3, net income $82.6 (4.0% of sales)
Waldenbooks - 2000 sales $ 944.3, net income 40.2 (4.3% of sales)
International - 2000 sales 219.1, net loss 10.2 (4.7% of sales)
Borders.com - 2000 sales 27.4, net loss 29.7 (108% of sales)
Borders is refreshingly candid about their plans. Borders business stragety is to use Waldenbooks as a cash cow, without significant expansion plans ("opportunistic store openings" is all) ; continue growth in its superstores and international division; convert its international division to profitability; and bring Borders.com to profitability. They will use "synergies and economy of scale" to control costs.
Earnings forecast: First Call is calling for EPS of $1.38 for this FY (end 1/02) and $1.57 for next FY. These would be growth, using their $1.15 number for FY00, of 20% and 13.8%. The AAII data disk gives an analysts growth rate of 16.2%. Is this realistic? I doubt it.
Looking at their divisions:
Waldenbooks: This is their cash cow, funding growth without the need for excess borrowing. (They have virtually no long term debt.) However, not only are they not opening many new stores, they are closing more. In 1998, 1999, and 2000 combined they opened 66 stores and closed 120. The pace of openings is slowing and of closings is increasing. Store count is down from 900 in 1998 to 869 in 2000. And net income is dropping sharply, both in raw dollars and as a percent of sales. We had income in dollars (millions) and as a percent of sales of:
1998 $61.0 6.4%
1999 $55.5 5.8%
2000 $40.2 4.3%
The drop for 2000 is partly a result of fewer stores and, more important, partly caused by a comprable stores sales decrease of 2.9%. This is not a good omen. Cash flow increased, which is good, but the earnings drop is not encouraging for long term growth.
International: This is a small segment. It has lost money each year, and the losses have been increasing, from $3.2 million in 1998 to $7.9 million in 1999 to $10.2 million in 2000. International consists of both Borders Superstores (5 in 1998, 9 in 1999, 14 in 2000) and the Books etc. chain in England (26 in 1998, 27 in 1999, 31 in 2000).
Borders.com This is still a tiny segment, but accounts for major loss. And losses have been mounting. Borders has recently signed an agreement for a co-branded site with Amazon, which will provide inventory, fulfillment, site content, and customer service. Borders will promote Amazon's site in its stores. Both companies said the deal won't change their previously issued financial guidance (MarketWatch story 4/11/01). Whether BGP will continue to show a loss on it's .com operations, or will simply show no profit, isn't clear. However, since no on-line bookseller is making money, there's no reason to think Borders will. At best they will move to break-even.
Borders superstores: If serious growth is to come, this is where it must come. The superstores accounted in 2000 for 63.6% of sales and virtually all the net operating income of the company (in 2000 net income from operations for the superstores was $82.6 million; the combined results for the other three divisions was $0.3 million).
Where is the growth here coming from? New store openings, for one. But planned openings are slowing down. Openings were: 1998, 43 stores; 1999, 46 stores; 2000 44 stores. But plans for 2001 are only 25-30 stores. Total stores were: 1998, 245; 1999, 291, 2000, 335. Thus, the store increase for ‘98 was from 202 to 245, or 21% store growth. If 30 stores are opened in 2001, the high end of the projected range, that will amount to only 9% growth.
Comparable store sales increases are down, too; 98-99 was 5.4%; 99-00 was 2.3%. Granted, this was a tough period for the market, including retail sales, but still. Net income as a % of sales is staying flat at 4%.
One unknown not discussed in the AR or 10-K is how soon stores become profitable. If it takes several years for stores to mature, then the division is being carried by perhaps 250 stores with about 100 still to mature. This would be a strong growth driver. OTOH, if stores mature quickly, most of the stores are fully accounted for in the present results.
Other observations: The synergies and economies of scale they talk about haven't shown up yet. In fact, SG&A expenses have not only been increasing, but have been increasing as a percentage of sales, from 21.5% in FY 98 to 22.1% in FY 99 to 22.5% in FY 00. With COS staying basically steady at about 72%, of sales though creeping up (71.7, 71.7, 72 in the last three FYs), operating income as a percent of sales has dropped in the past three FYs, 6.4% to 5.8% to 5.2%. There is no indication in their annual report or their 10-K that this is going to reverse.
Overall: At best, Waldenbooks will be stagnant. This segment represents 29% of sales. Thus, growth must come entirely from the other three divisions. International is not worth much at this point, only 7% of sales. Its losses have been mounting year by year, so the best that can be hoped for during the next year or two is that it will not have even higher losses. Figure it at the best not a factor in growth for the next two years, and at the worst a continued drain. Borders.com is gone. What will the result of the Borders-Amazon deal be on the bottom line? Nobody is saying, but the guidance isn't changing. Figure no change there. So, all the earnings growth for the next two years has to come from the Borders Superstores. Can the Superstores grow at 15% or more? The store count will go up 9%. Since it is likely that new sites won't be as profitable as the sites already filled and cherrypicked, figure maybe 7% increase in sales and earnings from new stores, if we're lucky. Same store sales increases were down to 2.3% last year, but the average of two years was about 4%. So allow 4% there, and assume (maybe not a safe assumption) the profit margins will hold up, for 4% profit growth. This gives us 11% growth in the superstores. Where is the rest of the 20% growth FirstCall forecasts coming from? Your guess is a good as mine. I don't see it. Eleven percent at best. Since it's quite possible that Waldenbooks profits will continue to drop as stores get closed and same stores sales are at best level, and since it's quite possible that the international division losses will mount for another year, I think a 10% growth figure is probably the most I feel comfortable with.
An Updated SSG:
So, for forecasting purposes I'm using a 10% growth rate on the SSG. I changed the AAII FY2000 EPS from .68 to $1.21, which is a better base for forecasting since there shouldn't be another All Wound Up type write-off in the future (unless there is a significant write-off of some .com assets). This would give 2001 EPS of $1.33 (vs. First Call of $1.38) and 2002 of $1.46 (vs. $1.57).
For the high P/E, the high P/Es for 1996, 1997, and 1998 were in the 30s, but for 2000 the high P/E was 14.7. The current P/E is 15.8. Being very conservative, I'll go with the 15. This gives me a five year forecast price of $29.2. For the low P/E, I used the historical low of 9.0. The range of options for the low price is from a forecast 6.1, which seems clearly too low, to a recent severe market low of 10.9, which I used.
Using 25/50/25 zoning, this gives zones of 10.9 - 15.5 - 24.6 - 29.2. This puts the current price well into the hold zone. (Even on 33-33-33 zoning the current price is in the hold zone.) The upside-downside is only 1.2. Annual return is only 8.8%.
This would suggest that we put BGP on our watch list, and if it reaches the bottom of the sell zone, 24.6, sell it. We might even put in a sell at that price, for a net after commission of $4,890.05. If this occurred within the next six months we would have an annualized return of 27.4%, and we would have milked most of the projected price gain out of the stock.
A contrary view:
There is a contrary view, and it would go like this.
Start with the net income for the divisions given above.
Borders.com has been dragging down earnings, and it is now history. Even if it isn't profitable, taking away the loss you add $30 million back into earnings.
International sales have been increasing at a rapid pace, nearly doubling in two years. Since Borders doesn't have the name recognition overseas that it has here, it will take longer for those stores to become profitable. But assume sales growth continues by just 25% annually from the combination of new stores and same store sales growth, in five years you have sales of $669 million. Allow a margin half that for domestic stores, or 2%, and you have profits of $13 million as opposed to loss of $10. That's a positive change of $23 million. (And if margins were the same 4% as they are stateside, you add more.)
Assume Waldenbooks simply stabilizes, and keeps throwing off cash, no change in earnings.
Let the Borders Superstore growth increase by only 10%. That's plenty to add $50 million to net income five years out.
So five years from now you have increased earnings by $103 million. Assume an increase in the present base of 78 million shares to, say, 90 million shares for issuance of stock options, this is an additional $1.14 per share. That gives five year earnings of $2.33. Plug this into the SSG, give a less paranoid P/E of 20, and your zoning suddenly becomes 10.9 - 19.8 - 37.7 - 46.6, with an u/d of 3.3 and an annual rate of return of 19.4%.
And, we note that the bad earnings for 2000, down from $1.17 to .54, will have scared off investors. Give Borders a few good years, and investors will rediscover Borders.
Conclusion:
We will be discussing the BGP annual report and this analysis at our meeting on the 27th. Come prepared with your comments and questions.
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