The Boring Portfolio, Nov. 30, 1998

<THE BORING PORTFOLIO>
Borders Patrol
The Motley Fool Book Review

by Alex Schay (TMF Nexus6)

ALEXANDRIA, VA (Nov. 30, 1998) -- Dale's back from Buffalo, and all's right with the world. Today we'll take a closer look at Borders Group, which we began discussing back on November 20th, after posting the company's third quarter conference call in the week prior. We concluded the previous Borders Group discussion by saying "we need to get a sense of what the company's incremental returns have been as it continues to build locations." That's where we're going today.

As any casual observer can figure out, the book business is seasonal. The large chain booksellers usually lose money, or make some paltry sum, in the first three quarters of their fiscal year (which usually overlaps the calendar year by a month). The holiday season is their saving grace, when they fatten up by gorging on huge revenues. These revenues more than make up for the losses incurred in the previous quarters, sustaining them through the lean periods. It would seem that holiday shoppers feign literacy for the holiday season, alternately buying and receiving books (along with ties and socks) as the generic gift of choice -- that is, if the illiteracy doomsayers are to be believed.

Along with fourth quarter sales comes a substantial deployment of capital in anticipation of the holy quarter. As we recounted in the Q3 conference call transcript, Borders made big investments in current accounts -- with payables almost doubling and inventory up 14%, as well as 25 Borders Superstores coming online, versus three in Q1 and seven in Q2. Just to get a sense of the company's unit growth over the last two years, here are some of the reported numbers at particular dates:

          (03/23/97)  03/22/98  YOY%  11/12/98  9mo.%change
Borders   158         204       29%   238       16.67%
Waldens   936         904       -3%   896       -0.88%
Books etc.  0          23        -     25        8.00%

Total    1094        1131        3%  1159        2.48%       
(Planet Music/Brentanos info. not avail.)

Overlaying this chart with some return information yields some interesting results, even though the unit build numbers don't neatly overlap with the financial results that are presented. It's important to note that the ROIC (return on invested capital) numbers don't reflect the conversion of operating leases.

Calendar (end)  1996     1997  (Chng.)  9 mos.'98  (Chng.)
(mil)               
Capital (avg.) 554.83  654.72   99.89   863.45     208.73 
ROIC            11.2%   12.9%       -

LT Liabilities:
LT Debt          6.2     5.2        -     6.0                 
other LT        24.8    50.2        -    53.9
  
Equity         511.4   598.1        -   625.8
LTL - equity      6%      9%        -      9%

We are going to hold off on calculating a "guesstimate" ROIC for this year, in favor of a look at Borders incremental return. That is, the company's marginal return on invested capital (ROMC) -- or the additional after tax operating dollars that are generated for every additional dollar added to capital. The after tax numbers are in parenthesis.

Income

Calendar (end)    1996   1997  Chng.  (AT change)  9 mos.'98  (AT)
Operating        103.1    138  34.90  (21.39)           20.1  (12.33)          
Net Income        57.9   80.2                                   5.4
Cash Flow         78.4  141.2                           
(before change in current acounts)
Cap Expenditures  97.2  113.6

ROMC                                   21.4%                     

Adjusted share price (01/27/96)  (01/27/97)  11/27/98
                      $18 5/16    $33 5/16   $25 1/4

As can be seen, Borders added about $99 million in capital in calendar year '97, in which it generated an additional $21 million in operating income, yielding an excellent ROMC of 21.4% (interesting to note, Borders' share price almost doubled during this period). Performing a similar, though obviously unfair, analysis for the first nine months of 1998 yields a ROMC of 5.91%. The firm added quite a bit of additional capital during the period, in the hopes that it will be vindicated in the fourth quarter.

Here's the interesting thing: assuming 6% operating margins on $2683.43 million in sales for the year (current I/B/E/S estimates), that results in $161 million in operating income -- which represents an after tax figure of $98.709 million. Even with the assumption that the company will grow its average invested capital by 40% year over year to $916.60 million (an incremental gain of $261.1 million), the Borders' return on marginal capital would be an excellent 37.8% for the year.

Borders is managing its capital build quite well, and despite some of the operational difficulties experienced this year (including the California combination and the new fulfillment center) it looks like it's on track. We tend to think Borders will emerge from the fourth quarter in substantially better shape than it went in. The question for us Boring managers, though, is whether or not we want to hang on to the business for another five or even ten years. We'll take a look at that issue, some EVA and cash flow projections, as well as the effects of converting operating leases to capital leases in a future column.

Though he's busy right now preparing videotapes and drafting a letter to the National Football League pointing out huge problems in the officiating of yesterday's Buffalo Bills - New England Patriots game, Dale will kick off our look at Berkshire Hathaway on Wednesday.

Until then, join us on the Boring Message Boards!

• Discuss Boring Investing on the Boring Port message board.
• 10/01/98: The New Boring Port Transitions Facts

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Stock  Change    Bid
ANDW  -1       16.00
BGP   -1       24.25
CSL   -1 9/16  44.31
CSCO  -4 7/16  75.38
FCH   -  5/16  23.75
PNR     ---    37.69
TBY   +  7/16  7.75

                   Day   Month    Year  History
        BORING   -2.84%   7.06%  -2.07%  23.23%
        S&P:     -2.40%   5.91%  19.91%  87.19%
        NASDAQ:  -3.32%  10.06%  24.15%  87.28%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96     75.38   214.65%
  2/28/96  400 Borders Gr    11.26     24.25   115.44%
  8/13/96  200 Carlisle C    26.32     44.31    68.33%
  4/14/98  100 Pentair       43.74     37.69   -13.84%
  5/20/98  400 TCBY Enter    10.05      7.75   -22.85%
  11/6/97  200 FelCor Sui    37.59     23.75   -36.82%
  1/21/98  200 Andrew Cor    26.09     16.00   -38.67%

    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  16959.38 $11569.39
  2/28/96  400 Borders Gr  4502.49   9700.00  $5197.51
  8/13/96  200 Carlisle C  5264.99   8862.50  $3597.51
  4/14/98  100 Pentair     4374.25   3768.75  -$605.50
  5/20/98  400 TCBY Enter  4018.00   3100.00  -$918.00
  1/21/98  200 Andrew Cor  5218.00   3200.00 -$2018.00
  11/6/97  200 FelCor Sui  7518.00   4750.00 -$2768.00

                             CASH  $11273.22
                            TOTAL  $61613.84