Boring Portfolio

<THE BORING PORTFOLIO>
Bordering on Closure
Plus, the Week in Review

By Alex Schay (AlexWS@fool.com)

Alexandria, VA (Jan. 8, 1999) -- Today, we'll jump right into our analysis of what happened with Borders Group (NYSE: BGP) yesterday. First let's go back to the guidance that Border's gave during its third quarter conference call. Recall that management reaffirmed its expectation of meeting the $1.22 earnings per share estimate for fiscal year 1999 -- meaning that $1.14 per share was expected in the company's crucial fourth quarter. Implicit in that figure was comparable store sales between 4.0% - 4.5% at Borders, and no worse than -1.0% comps at its Waldens locations. Yesterday, Border's announced that "the Company will not achieve sales necessary in the fourth quarter to meet the consensus earnings estimate."

The firm is now calling for fourth quarter comps at Borders to increase approximately 2.0% - 2.5%, and Waldenbooks comps are expected to decrease approximately 0.0% - 0.5%. So, on the low-end, Borders comps are probably going to be roughly half what was previously expected, and Walden's comps will come in 50% better than expected (in the worst case).

With sales at its eponymous stores off almost 200 basis points, one would expect a pretty serious EPS hit, no? Actually, Borders states that it still expects earnings per share of approximately $1.14 - $1.18 for fiscal 1998, or $1.07 - $1.11 for the fourth quarter -- which is below the consensus earnings estimate by only 4% to 7%. The missing part of the equation is the fact that gift certificate sales were huge in the quarter -- with the company calling for a 40% increase in comparative store numbers.

Note, the term "revenue" was not used. Gift certificates, although paid for, are classified as deferred revenue (which is a liability) until the company coughs up the books. Remember, Borders hasn't rendered the service that has been paid for by the customer until a book goes out the door. Thankfully, no potential "reserve charge" issues will arise, since the cards cannot be exchanged for cash (or for books and then for cash you devious).

Borders expects that "consistent with historical redemption patterns" about "30% of gift certificates sold in December will be redeemed in January." This translates into another 150 basis point impact on Borders' comparable sales in the fourth quarter. So, Borders' comps -- formerly around 2.0% to 2.5% -- will probably be more on the order of 3.5% to 4% after all those gift certificates are redeemed. The key word here is probably. The shift from "confidence" in EPS of $1.22 to the probability of $1.14- $1.18 is what hammered the stock about 20% yesterday

In addition, the company noted that "Major winter storms in strong Borders markets are expected to impact overall comparable store sales approximately 100 basis points." Although this sounds completely lame, we'll pass on the company's spin on the numbers: "Including the benefit of gift certificate sales [150 basis points] and excluding the impact of January storms [adding back 100 basis points], Borders' fourth quarter comparable store sales are projected to increase approximately 4.5% to 5.0%."

According to Borders, 90 of its 250 Borders stores were impacted by storms on New Year's weekend in the Midwest -- ostensibly a key sales period. We'll overlook the fact that similar weather hit the region in December last year, and that New Year's is a post gift-giving period. The opening line in the Borders press release on the matter is telling: "Borders Group, Inc. (NYSE: BGP) today announced, due partially to the impact of major storms in key markets over the last week, the Company will not achieve sales necessary in the fourth quarter to meet the consensus earnings estimate."

Of course, the company will say the line is to hedge its remarks about gift certificates, but conspicuous in its absence is commentary about the net threat (aside from the line stating that its own net operations will lose a more than expected $0.12 to $0.14 for the year). In previous Bore Port columns we have attempted to frame the debate regarding the possible impacts that net sales would have on Border's fourth quarter numbers:

"The inherent problem with the Holiday season business model of the traditional booksellers is the following: If the 'gift purchase' is truly born of convenience, then that convenient gift is likely to be matched by a convenient purchase if it's available to a sufficient amount of people. Check out this study conducted for Marketing News."

The convenience this time around was matched by a large unexpected jump in gift certificate cards -- which management wasn't even sure would hit stores in time for the Holidays -- and, of course, online sales. The work that I've done on the matter has led me to believe that online sales (other than at Borders.com) shaved about 100 basis points worth of comps from Borders. While that seems pretty significant, Borders is still generating an economic return on its unit build. Even with a rough year -- assuming Borders reports on the low end of its guidance -- the company is going to generate $90 million in after-tax operating earnings, off of an average invested capital base of $882 million.

Build the stores and people will still come to buy books -- even with the Internet. While I don't like the business model with the fourth quarter nail biting and the intensive capital build-up through the course of the year, I still think it's cheap in relation to the cash it can bring in. Taking a look at an EVA analysis from the linked Excel spreadsheet. The weighted average cost of capital shows an equity component consistent with compound returns for most of this century (and for a company with certainly no more risk than the average equity, considering the steady unit model).

In this model, Borders will generate a modest but steady return over its cost of capital on into the future. Included is also a spreadsheet with the vital stats on Borders. Dale will have more on this on Monday. Have a great weekend and good luck to those of you with teams in the NFL playoffs.

We hope we see you on the boards on the message boards!

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01/08/99 Close
Stock  Change    Bid
ANDW  +1 1/8   18.81
BGP   -  3/8   19.63
CSL   -  1/2   51.75
CSCO  +3 1/16  106.69
FCH   -  1/8   22.75
PNR   +  7/8   40.31
TBY   +  3/16  6.75
                   Day   Month    Year  History
        BORING   +1.18%   2.06%   2.06%  37.04%
        S&P:     +0.43%   3.74%   3.74% 111.85%
        NASDAQ:  +0.79%   6.92%   6.92% 125.22%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96    106.69   345.36%
  8/13/96  200 Carlisle C    26.32     51.75    96.58%
  2/28/96  400 Borders Gr    11.26     19.63    74.35%
  4/14/98  100 Pentair       43.74     40.31    -7.84%
  1/21/98  200 Andrew Cor    26.09     18.81   -27.89%
  5/20/98  400 TCBY Enter    10.05      6.75   -32.80%
  11/6/97  200 FelCor Sui    37.59     22.75   -39.48%

    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  24004.69 $18614.70
  8/13/96  200 Carlisle C  5264.99  10350.00  $5085.01
  2/28/96  400 Borders Gr  4502.49   7850.00  $3347.51
  4/14/98  100 Pentair     4374.25   4031.25  -$343.00
  5/20/98  400 TCBY Enter  4018.00   2700.00 -$1318.00
  1/21/98  200 Andrew Cor  5218.00   3762.50 -$1455.50
  11/6/97  200 FelCor Sui  7518.00   4550.00 -$2968.00

                             CASH  $11273.22
                            TOTAL  $68521.65


</THE BORING PORTFOLIO>