Friday, January 25, 2008

The Case for Borders

Whitney Tilson was kind enough to send this to me regarding Borders (BGP)

Borders Group (BGP), Kian Ghazi, Hawkshaw, 9/07

Here’s a pitch on Borders…we’ve taken advantage of a significant pull back to ramp the position to one of the larger investments in our fund. We’ve been involved with Borders (BGP) for over a year now. Currently trading at ~$15.50, we believe BGP is worth at least $30/share with scenarios that could make it worth $35-45/share over time. Importantly, our view is in no way predicated on a merger or sale of BGP.

BGP has three divisions: Super Stores, Walden Books and an International Division (primarily UK and Australia). In March 2007, BGP management proposed a turnaround plan for the business that called for the divestiture of the International business, the closing of 250 of 564 Walden locations, and a renewed focus on every operational aspect of the Super Store business. BGP is in the midst of a multi-year capital spending program that has depressed historically strong free cash flows. However, we believe that the capital spending in the areas of inventory systems, store remodels to reduce sq. ft. to music (a major drag on comps the last few years), and development of an online channel represent the proper strategy to allow the Super Stores to generate a 9% EBITDA margin by 2009. This 9% margin is below past peak margins of 9.5-10% achieved as recently as 2004-2005. To generate this margin, one has to believe that the Super Stores can achieve a 2% comp and generate a 28.5% gross margin (vs 29.5% GMs in 2004-2005) as they reduce exposure to music and refine the loyalty program, which was launched in 2006.

BGP also has a significant working capital opportunity in the form of increasing inventory turns. BGP currently turns inventories at 1.6-1.7x vs. competitor Barnes and Noble at >2.5x. This gap represents a ~$500mm opportunity (vs the current EV of $1.3bn using average debt and cash). Importantly generating at least $200mm of this improvement is firmly with management’s control as they redefine current store level inventory management decisions and invest in new IT systems to go along with the recently added new distribution center.

Assuming that BGP can:

1. Get to 9% EBITDA margins in 2009 in its super store segment,
2. Generate $200mm of working capital from improved inventory turns.
3. Sell its International Business for $100mm [~0.2x estimated 2006 revs of assets for sale], and
4. Reduce current capex spending to ~$100mm starting in 2008,

Applying a 7.5x EBIT multiple to 2009 EBITDA-Maintenance Capex of $250mm (we use $75mm of maintenance capex to be conservative vs. management guidance of ~$50mm) suggests a value of $30 share. We use EBITDA less maintenance capex because depreciation is overstated.

The ~$40/share scenario comes from the possibility that BGP may be able to close the sales productivity gap between it and BKS. The $30 scenario assumes no improvement in relative productivity. However we believe that if BGP management can address the current problems in the business, it will then have a credible operating platform to attempt to address this productivity gap, which we believe is largely driven by BKS’ seasoned loyalty program, superior Starbucks productivity, and higher margin merchandise mix. In addition, a more rationale pricing posture between Borders and Barnes and Noble could dramatically improve the ROIs of both companies.

Now, with Ackman pushing his ownership to 18% and his economic stake to 26%, I think it is time to get on board here. These number make sense and are doable. With Pershing on the Board now, one can only assume management will begin to take step to accomplish these metrics.

Disclosure ("none" means no position):None

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