Dueling Fools: Borders Bear

Before I tell you why I'm a bear on Borders Group (NYSE: BGP  ) , let me tell you a quick story.

My wife and I visited our local Barnes & Noble (NYSE: BKS  ) last week. People filled the aisles and chairs and the Starbucks coffee percolated. We went on separate adventures and rendezvoused an hour later, each carrying our load of books. Then we looked at each other and decided we could save money by ordering them from Amazon.com (Nasdaq: AMZN  ) .

I don't know exactly how many people do this very same thing, but I watched the line for the register for quite a while and wondered why I didn't see many people checking out. This may not be happening at Borders and I am not going to extrapolate my experience, but it makes me wonder, because I can't be the only one to act this way.

It's not a bargain
When a retailer has a price-to-sales ratio of 0.47, the first thing I think is, "This is a potential bargain." With my appetite whetted, I look for additional clues to see if the stock is a value or a value trap.

A price-to-sales ratio much less than 1 implies that sales do not create value. Borders is no exception, as seen from the operating margin and return on invested capital (ROIC) data below.

FY2002

FY2003

FY2004

FY2005

FY2006

FY2007

Operating Margins

5.6%

5.7%

5.7%

5.7%

4.4%

1.2%

ROIC

12.7%

11.7%

11.2%

11.5%

9.4%

5.0%

FY ending stock price

$23.73

$15.42

$21.61

$25.80

$24.28

$21.29

Author's calculations

The only way to get the ratio up is to turn things around and get the operating margin going in the right direction. If capital is allocated Foolishly during the process, then the ROIC should rise as well. Getting ROIC back up to pre-2006 levels will mean the company is creating value again. Can Borders do that? Color me unsure.

Some performance data from the latest earnings release make me think Borders has lost its bookmark. The average ticket at its superstores increased 2% and the units per transaction 4%. But paying customers decreased 4%. So even with its loyalty program, fewer customers made purchases. And with all the promotions, the ones that did buy more books generated lower operating margins. Sorry, folks -- that's not good.

Sure, the company is revamping the program to get more of its loyal customers through the doors and making more purchases, but it has to make profitable sales along the way. Otherwise, the customer is capturing more of the value than shareholders are. That's not the way to generate blockbuster returns.

In March, Borders announced that its new, proprietary e-commerce site, Borders.com, will be ready in early 2008. How am I supposed to get excited about a "new" book-selling site that's still a year away? Isn't that why I go to Amazon.com right now: because it already has a very, very good website? This seems too little, too late.

Strategic initiatives
Back in March, the company laid out its goal of reaching "EBIT margins of 5% to 6%" at its superstores. Superstores are the focus right now as the company gets back to its core -- its words, not mine. So let's say that Borders does earn 5%-6% operating margins; how much will the market be willing to pay for those shares? If we go back to the table above and use those year-end prices as a very rough guide, I would say not more than the price being offered today. That's because I think the market is already looking ahead and pricing the company as if it's already accomplished those goals. So why would I want to invest in a company that, by 2009, will finally get things back on track and yet not have much of a chance to earn any returns along the way? That's right, I won't. I don't think an investment in Borders is a good one.

I'm not buying
There's certainly plenty of pessimism surrounding the company, and that usually leads to lower prices. But the stock price hasn't dropped nearly far enough to turn the page and purchase shares. To summarize, I think the company gives away too much value to customers because the industry is so competitive -- besides Barnes & Noble and Amazon, let's not forget Books-A-Million (Nasdaq: BAMM  )  and plenty of mom-and-pop bookstores. And since I think the stock market already seems to be pricing in a successful turnaround, there's doesn't seem to be any upside for my benefit.

Sorry, folks -- I love the books, but I don't like the bookseller. I'll pass.

You're not quite done yet! If you missed the bull's argument, it's here. If you've already read everything, cast your vote for the winner here.

Borders Group is a Motley Fool Inside Value recommendation. To get Philip Durell's thoughts on why, all you have to do is click on this link to take your free 30-day trial.

Retail editor and Inside Value team member David Meier is ranked 1,168 out of 29,570 in CAPS and does not own shares in any of the companies mentioned. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.


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