Boring Portfolio

A Tale of Two Bookstores
Bifurcation in the book market

by Alex Schay (TMF Nexus6)

ALEXANDRIA, VA (Jan. 22, 1999) -- Lately, Dale's been quite a choc-o-holic and I've been reminded of sweet business returns in general. In one of our early Industry Snapshots, we took on the topic of "Non-Store Retail," which at the time (5/30/97) was really the only credible description we could muster for the inchoate "e-tailing" universe -- it included a smattering of catalog companies as well as a few firms that did a solid minority of their business online. One pure play that emerged to take center stage "In the Spotlight" was Inc. (Nasdaq: AMZN) -- ever heard of it?

Silly question, but you probably wouldn't have recognized the firm at the time. The company made its debut that month at $29 1/4, and had silently slipped to $18 when we profiled it. Of course, the key feature of our analysis at the time was the "promise" of the Internet operating model:

"The best part of's operating structure is its low PP&E [property, plant, and equipment] and low inventory requirements. Amazon's net equipment on the books of $2.49 million generated $30.87 million in trailing sales, translating into an excellent $0.08 for every dollar of sales. The company's meager inventory of $939,000 translates into a pittance, $0.03 of inventory for every dollar of sales. Since doesn't order its books until the customer does, Accounts Receivable are kept out of the picture. All of these operating dynamics only get better as economies of scale are realized."

Well, almost two years later the question of whether or not has fulfilled its promise is still raging on -- in tandem with the upward price movement of the stock -- despite the fact that it officially holds the title of "Largest Online Shopping Site in the World." As Dale outlined in a Fool on the Hill column last fall, the real issue is not "mania" but rather the return characteristics of the business. We're still talking retail here. It doesn't take a genius to peruse the inventory turnover and cash conversion cycle lines to figure out that the operating economics of the online retailer are far superior to the conventional bricks and mortar bookseller. Here's how the public bookworms look, side by side:

                            BGP     BKS    BAMM     AMZN
Working Capital           94.90  400.21   81.39   275.20   
Inventory Turnover         1.70    2.14    1.15    29.31   
Capital Turnover           2.84    3.03    1.82     4.79   
Days in Inventory        228.64  180.66  317.61    15.18   
Days Sales Outstanding    10.32    8.09   16.91       NA   
Days in Payables         127.89  106.70  143.04    46.11   
Cash Conversion Cycle    111.06   82.06  191.48   -30.93   
Asset Turnover             1.45    1.67    1.05     1.25   
Assets/Equity              3.05    3.55    2.92     3.12   
PP&E Turnover              6.20    3.93    2.82    29.98   
Gross Margin              28.17%  28.47   27.20%   22.06%   
Operating Margin           6.05%   4.11%   6.36%   -4.59%   
SG&A/Sales                21.70%  21.03%  18.30%   34.33%   
Net Margin                 3.46%   1.30%   3.12%   -7.17%   
So, in light of simple earnings growth projections (which say nothing about the profitability of the growth) for the coming year -- currently 19.83% for BGP, 57.50% for BKS, 28.00% for BAMM, and 69.03% revenue growth for AMZN -- how are these companies being valued in the marketplace? Looking at the numbers below, a couple of seemingly odd things stand out. Borders, with the best margins in the business and the only firm to actually be earning a spread on its cost of capital, is valued at even less than industry laggard Books-A-Million on almost every metric displayed. How can a firm with trailing sales of $2.5 billion be had for $1.6 billion, while its chief rival with roughly the same sales is priced at twice that amount -- or for that matter a firm with less than one fifth of the sales is valued at 3.5 times Borders? The answer is of course, once again, the "promise" of the Internet. Real earnings now are being discounted in favor of the prospect of mammoth returns later.

                          BGP        BKS     BAMM        AMZN
Market Cap          $1,655.40  $2,718.16  $211.02     $22,140   
Enterprise Value    $1,661.40  $3,166.06  $257.94     $22,481   
Trailing Revenues   $2,508.30  $2,983.97  $305.09     $423.11   
Operating Earnings    $151.80    $122.59   $19.39     -$19.41   
EV/Revenues              0.66       1.06     0.85       53.13   
EV/Invested Capital      1.66       3.03     1.45      122.38   
EV/Assets                0.91       1.70     0.88       36.27   
Price/Book Value         2.65       5.10     2.08      123.16   
PSR                      0.66       0.91     0.69       52.31   
EPS                     $1.05      $0.57    $0.55      -$0.60   
P/E                     19.09      70.06    22.15          NA   
EV/Operating            10.94      25.83    13.30          NA   
EV/Net Income           19.16      81.60    27.07          NA  
EV/FCF                 -23.17     -97.47   -16.10      -1,039   
EV/NCFO                 20.59      25.72  -183.72          NA   
trailing figures in (000,000)

(Remember: These trailing numbers reflect the inclusion of the prior year's Q4, while also containing the capital build-up for the most current year. The figures are inherently depressed.)

Barnes & Noble is looking to grab roughly $65-$70 million in online revenues for the current year (split with its partner), for which it is projected to lose ($0.57) per share, compared with which is projected to come in with revenues of roughly $560 million for the year, on which it will lose an estimated ($0.55) per share. Both these companies are spending heavily on promotion and development of their online operations -- which hurts margins now, but is expected to pay off down the road.

Hang on, doesn't Borders have a website, too? Looking at the numbers, you feel like you're staring at a web-less shell of a company, a bloated, bricks and mortar behemoth, way behind the times. Borders does indeed have a website, but let's call it "web-lite." Most of the money spent so far has been for development of the actual site itself rather than promotion, which means that sales growth is lagging behind Barnes & Noble and Amazon but that the firm will be profitable faster (in theory anyway). Borders is looking to bring in roughly $25 million in online revenues for the current year, and announced that it expects to lose between ($0.10 -$0.12) in earnings per share. Not too bad.

One of the things that most investors don't understand about Borders is that it is consciously pursuing a conservative Internet strategy. Management has done the numbers and wants to raise awareness about the firm's buildings! It is not a market share strategy, because Borders thinks that it can grow and continue to make money while pursuing a "build it and they will come" model (documented in a previous return on marginal capital analysis). In this way Borders is staying focused on its capital investment strategy of building superstores, and thus has simultaneously been characterized as burying its head in the sand in order to ignore the writing on the computer screen (mixing and modify metaphors is fun).

Investors have been given the task of recognizing a bifurcation in the book market, where a certain class of buyers -- in actuality, the overhwhelming majority despite all the hype -- are still going into bookstores. Failing that, investors should at least acknowledge that purchasing behavior formed over many hundreds of years is not going to change overnight. That's why now is such a crucial time for the business, and why this new uncertainty about the fourth quarter has really hurt Borders.

At these levels though, investors don't have to even have to buy in completely to management's steady, earnings visibility story. Borders is priced like it's going out of business. While this columnist would be the first one to acknowledge the limitations of relative valuation, Borders has plenty of room to continue to increase its return on operating assets. This is due in part to its present focus of spending on unit build. Incidentally, the cash flow characteristics don't differ markedly from the other operators:

                                  BGP      BKS     BAMM     AMZN
Cap Ex                        $152.40  $155.59   $14.62   $21.60   
Working Capital Change         $75.40   $64.64   $17.80   $38.72   
Net Op. Cash Ex. WC Change    $156.10  $187.75   $16.39  -$38.74   
Net Cash from Operations       $80.70  $123.11   -$1.40   -$0.02   
NCFO/Reported Earnings          93.08%  317.29   -14.74%    0.07%   
Cap Ex/NCFO                       189%     126%      NA       NA   
Cap Ex/Begin Invested Capital   15.25%   14.91%    8.21%   11.76%   
FCF                           -$71.70  -$32.48   $16.03  -$21.62   

Increasing returns on its operating assets will also be derived from the economics of its self distribution model (90% of its books are bought directly from publishers, that's why the Barnes & Noble/Ingram deal is still a non-event for Borders). Well, this is all just grist for the mill -- until we get word about fourth quarter numbers next week. In the meantime, we hope we see you on the boards. Have a great weekend!

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01/22/99 Close
Stock  Change    Bid
ANDW  -  7/16  18.88
BRKb  -10      2075.00
BGP   -  9/16  18.69
CSL   -  5/16  45.69
CSCO  +1 1/2   102.81
PNR   +  5/16  40.00
                   Day    Month   Year  History
        BORING   -0.13%  -3.81%  -3.81%  29.15%
        S&P:     -0.78%  -0.30%  -0.30% 103.87%
        NASDAQ:  -0.25%   6.67%   6.67% 124.68%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96    102.81   329.18%
  8/13/96  200 Carlisle C    26.32     45.69    73.55%
  2/28/96  400 Borders Gr    11.26     18.69    66.02%
 12/31/98    8 Berkshire   2244.00   2075.00    -7.53%
  4/14/98  100 Pentair       43.74     40.00    -8.56%
  1/21/98  200 Andrew Cor    26.09     18.88   -27.65%

    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  23132.81 $17742.82
  8/13/96  200 Carlisle C  5264.99   9137.50  $3872.51
  2/28/96  400 Borders Gr  4502.49   7475.00  $2972.51
  4/14/98  100 Pentair     4374.25   4000.00  -$374.25
 12/31/98    8 Berkshire  17952.00  16600.00 -$1352.00
  1/21/98  200 Andrew Cor  5218.00   3775.00 -$1443.00

                             CASH    $455.72
                            TOTAL  $64576.03