Boring Portfolio

The Book on Borders
...Continuing the Borefolio review

by Greg Markus (TMFBoring@aol.com)

ANN ARBOR, Mich. (Sept. 9, 1998) -- U.S. equities gave back a chunk of Tuesday's gains today, with the S&P falling 1.69% and the Nasdaq losing 2.19%. Small-cap issues, a class of stocks in which the Boring Portfolio is heavily invested, have shown signs of strengthening in the past week or two, but not so today. The Russell 2000 index tumbled 2.55%. As for the Boring Portfolio, it lost 2.19%.

In Tuesday's Recap, we initiated a review of the current Borefolio holdings, focusing on Atlas Air (NYSE: CGO), the small but rapidly-growing international air freight company based in Golden, Colorado. The objective of our review is to focus not only on the potential upside for each company (and its stock) but also to point to what we see as some reasons why a given stock might not be everyone's cup of tea.

The spotlight shines tonight on Ann Arbor-based Borders Group (Nasdaq: BGP). Borders Group is, of course, the world's second largest retailer of books, music, and related products. The company includes Borders Inc., with over 200 superstores; Waldenbooks, the leading mall-based book retailer in the U.S., which operates almost 900 stores serving all 50 states; Borders Online, which operates the e-commerce site, Borders.com; and Borders (UK) Ltd, which operates 23 "Books etc." stores, a leading bookseller in the United Kingdom.

Borders Group is the longest-held member of the current Borefolio. I purchased 400 shares of BGP (adjusted for a two-for-one split in March 1997) in February 1996 at a split-adjusted price of around $11. As outlined in the original "buy" report, the primary factors driving the purchase were the prospects for strong growth associated with the rollout of the Borders superstores, rationalization of Waldenbooks chain to enhance profitability, an experienced management team to pull this all off, a singular focus on providing the customer with excellent service and an outstanding selection, and an attractively priced stock.

The Upside from Here

The bullish case for Borders remains essentially the same as it was nearly three years ago. The superstore rollout continues on pace domestically, and early indications are that the international expansion is going exceptionally well. In its first year in business, the Singapore store has already become a major destination for locals, and the recent grand opening of Borders on Oxford Street in London was very well-received. Borders are opening soon in Brighton (England), Glasgow (Scotland), and Melbourne (Australia). The closing of less profitable Waldenbooks stores has been substantially achieved, and in fact a modest expansion is under way in so-called "nontraditional" sites, such as airport terminals.

Borders.com will at last enjoy its grand opening later this month, accompanied by a substantial marketing effort. Borders has repeatedly pushed back its target date for launching the e-commerce site; on the other hand, the September launch is reportedly rock solid, and unlike its competitors, Borders has refused to spend lavishly for Web "real estate" and expects to be able to turn a profit on its Website operation comparatively quickly.

All in all, Borders management endorses a target of 25% annual growth in sales and profits into the next century. And so far they have met or exceeded expectations in every quarter since the company went public in mid-1995. Margins have improved steadily, cash from operations is positive, and the balance sheet is strong, with long-term debt and capital obligations at less than 1% of total assets.

At a current price of $24 1/2, BGP trades at 20 times projected earnings of $1.22 per share for the fiscal year ending in January and 16.2 times projected EPS of $1.51 for fiscal 1999. Historically, the stock has traded with a p/e in the mid-twenties, compatible with its consistent earnings growth. This suggests a near-term target price close to $40 -- a value that was achieved in July when the overall market peak coincided with news that BGP would be added to the S&P Midcap index.

Risks

The downside case can be stated succinctly: books and music are well-suited for selling over the Internet, and retailers in those categories face the prospect of net margins approaching zero asymptotically as their commerce takes place in the frictionless market of the Web. The situation for Borders is rendered even more precarious in the bear's scenario, because it has lagged behind Amazon.com (Nasdaq: AMZN) and Barnes & Noble (NYSE: BKS) in achieving "mindshare" -- even leaving aside the pending competition from international media giant Bertelsman.

(That the "mindshare" assertion may be at odds with the "frictionless commodities market" claim is a matter we'll leave for some other day. We also wonder whether the costly single-pick-and-ship fulfillment side of book selling via the Web is nearly as frictionless as some e-commerce zealots may believe.)

Laid over all is the fact that -- for now, at least -- equities investors have been willing to support Amazon's (and, to a lesser degree, B&N's) quest to maximize sales essentially without regard for profits -- selling dollar bills for ninety-five cents, as one skeptic put it. It's damn tough to make a profit in such an environment.

Bottom Line

I have to believe that, sooner or later, investors will come to value profits over sheer sales, and that can only redound to Borders Group's benefit. I also believe that bricks-and-mortar bookstores won't fade away as e-commerce booms (which it surely will). There's a place for both. Indeed, the fact that Borders has been able to achieve its sales and profit targets in the face of the Amazon's surge suggests that much of the Web-initiated sales are incremental to the global book selling market rather cannibalizing sales from the bricks-and-mortar guys.

If you believe all that, then BGP looks like a compelling buy. If you don't, it may not be.

Either way, you'll want to check out Louis Corrigan's review of Borders in The Motley Fool's "Daily Trouble" section.

FoolWatch -- It's what's going on at the Fool today.


09/09/98 Close

Stock  Change    Bid 
 ANDW  -  15/16 14.06 
 CGO   -  15/16 21.81 
 BGP   -  1/16  24.50 
 CSL   -1 1/4   38.00 
 CSCO  -3 13/16 90.81 
 FCH   +  1/16  21.50 
 PNR   -  3/16  30.38 
 TBY     ---    6.31 
  
 
                   Day   Month    Year  History 
         BORING   -2.19%   7.83% -16.21%   5.44% 
         S&P:     -1.69%   5.08%   3.69%  61.87% 
         NASDAQ:  -2.19%   8.36%   3.45%  56.06% 
  
     Rec'd   #  Security     In At       Now    Change 
   6/26/96  150 Cisco Syst    35.93     90.81   152.73% 
   2/28/96  400 Borders Gr    11.26     24.50   117.66% 
   8/13/96  200 Carlisle C    26.32     38.00    44.35% 
    3/5/97  150 Atlas Air     23.06     21.81    -5.40% 
   4/14/98  100 Pentair       43.74     30.38   -30.56% 
   5/20/98  400 TCBY Enter    10.05      6.31   -37.16% 
   11/6/97  200 FelCor Sui    37.59     21.50   -42.80% 
   1/21/98  200 Andrew Cor    26.09     14.06   -46.10% 
  
     Rec'd   #  Security     In At     Value    Change 
   6/26/96  150 Cisco Syst  5389.99  13621.88  $8231.89 
   2/28/96  400 Borders Gr  4502.49   9800.00  $5297.51 
   8/13/96  200 Carlisle C  5264.99   7600.00  $2335.01 
    3/5/97  150 Atlas Air   3458.74   3271.88  -$186.87 
   4/14/98  100 Pentair     4374.25   3037.50 -$1336.75 
   5/20/98  400 TCBY Enter  4018.00   2525.00 -$1493.00 
   1/21/98  200 Andrew Cor  5218.00   2812.50 -$2405.50 
   11/6/97  200 FelCor Sui  7518.00   4300.00 -$3218.00 
  
                              CASH   $5750.59 
                             TOTAL  $52719.34